Does your construction company have enough resources to perform the work in current backlog? Working capital is a key financial indicator that can help answer this question.
The basic equation for working capital is: Current Assets – Current Liabilities = Working Capital. Creditors and bonding companies will typically reduce working capital (Adjusted Working Capital) to disallow certain current assets that they consider non-liquid or unreliable. The disallowed assets in Adjusted Working Capital are internally determined by the creditor or bonding company to meet their standards when determining credit or bonding capacity. The most disallowed current assets are inventory, prepaid expenses, related party receivables and past due receivables (some accountants will refer to these as “junk assets”). These assets can be fully or partially disallowed by the creditor or bonding company as set by their standards.
Working capital can be used to determine how much backlog the company can carry without stressing its financial resources by applying a multiple to the company’s working capital (Target Backlog). A general guideline is to use a multiple of 10 for most small to medium size trade contractors, while larger companies and general contractors that subcontract most of their work use multiples higher than 10. For example, a small trade contractor with working capital of $500,000 that uses a multiple of 10 has a Target Backlog of $5 million (Working Capital x Multiple = Target Backlog)
With target backlog a company can calculate a target annual volume by multiplying target backlog by the average job turnover. If the average job last three months, the company turns an average job over four times a year. Continuing the example above, with target backlog of $5 million and work turnover of four, this company has a target annual volume of $20 million (Target Backlog x Job Turnover = Target Annual Volume)
Although it can be tempting to take on large projects, it is a good practice to reduce risk and not to put more than half of a construction company’s total backlog in one job. This helps ensure that a construction company can deliver on its contracts without the financial stress and risks that can come from too much work.
Since working capital is a key financial indicator, a company should monitor and work to increase its working capital as part of the company’s financial and growth strategy. A company should understand how particular transactions affect or don’t affect working capital so they can be managed in accordance with the company goals and strategies. Working capital increases when jobs are profitable, borrowing on long-term notes rather than paying in cash, selling long-term assets like machinery. Working capital decreases when a company does the opposite, jobs are not profitable, buying long-term assets with cash and paying off long term debt. Working capital does not change when borrowing money on a short-term basis, collecting receivables, or paying payables.
These are important and proven guidelines that can help construction companies grow at a steady pace. Be on the lookout for my upcoming blogs as we dive in further into other important financial indicators that are key for companies in the construction industry.
For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.