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A Contractor’s Guide to Working Capital: Managing & Measuring Liquidity
Last Updated Nov 16, 2023
Effective evaluation and management of working capital is a critical component of business management — and can be the key to success for many contractors. In this article, we will discuss how contractors calculate working capital, and why it’s important. We’ll also explore a few best practices for construction companies to manage and improve working capital.
Table of contents
What is working capital?
Working capital, also called Net Working Capital (NWC), is the difference between a company’s current assets and current liabilities. Current accounts are those that are due (collectible or payable) within one year or less.
A contractor’s working capital is a financial measure of the company’s liquidity — in other words, it measures their ability to make payments to creditors.
Learn more: Types of Capital for Construction Businesses
Current assets are cash and other assets that can be converted to cash, typically one year or less. Examples of current assets include:
- Cash on hand (e.g. checking or savings account balances)
- Raw materials
- Accounts receivable
- Prepaid liabilities
- Marketable securities
Current liabilities are all those bills that are due in one year or less. Examples of current liabilities include:
- Wages owed (for work performed but not yet paid)
- Payments due to vendors, suppliers, and subcontractors
- Short-term debts (e.g. credit card balances)
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How to calculate working capital
Here’s the formula to calculate a contractor’s working capital:
Working Capital = Current Assets – Current Liabilities
Thus, calculating working capital allows a contractor to determine whether they have access to sufficient cash to pay bills in the near term. The formula only looks at “current” assets and liabilities because these are short-term measures.
Of course, the working capital formula contains an inherent assumption that contractors can convert current assets into cash quickly. While true in theory, some current assets can be difficult for contractors to convert into cash.
For example, while retainage receivable is considered a current account (collectible within one year), it is not uncommon for contractors to wait a year or longer to collect retained funds, depending on the contract and project duration.
Working capital vs. cash flow
Cash flow and working capital are closely related, but there are a few key differences between them. Cash flow is the difference between inflows and outflows of cash, while working capital is the average difference between short-term assets and short-term liabilities.
In general, working capital paints a picture of the financial health of the business overall, while cash flow is a better measure of a contractor’s financial health day-to-day — or on a project level.
Potential creditors want to see healthy working capital, because a contractor can theoretically sell short-term assets to cover loan payments or bond claims even if they are low on cash. Healthy cash flow is arguably more important for daily operations — after all, subcontractors and vendors don’t accept non-cash assets as payment.
Although they are more liquid than long-term assets like equipment, short-term assets still take time to convert into cash. Inevitably, some accounts receivable will be uncollectible, and inventory damaged or unsellable.
While positive cash flow can lead to an increase in working capital, this is not always the case. For example, if a contractor takes a loan and deposits the funds in the bank, this transaction will improve the company’s cash flow. But because the amount will also be recorded as a short-term liability (accounts payable), working capital would remain unchanged.
Ultimately, cash flow management is just one part of working capital management.
Working capital turnover
While working capital gives you a snapshot in time, it doesn’t tell you how effectively a company is actually using working capital to drive sales. Working capital turnover measures how efficiently a company is using each dollar of working capital to generate revenue.
Here’s the formula:
Working capital turnover = Net Revenue ÷ Net Working Capital
To calculate an accurate turnover ratio, time periods for both revenue and net working capital (NWC) should be consistent. NWC is calculated by averaging the working capital balances at the beginning and end of the period.
A higher working capital turnover rate is better, as it indicates a contractor is more effectively using their working capital to generate revenue. For example, a working capital turnover ratio of 5 means the company is generating $5 in sales for every $1 in working capital employed.
Conversely, if a company has a low working capital turnover ratio, they are not efficiently using their working capital to generate sales.
According to IBISWorld data, average working capital turnover for contractors typically ranges between 3 and 7, but that figure can vary widely between sectors. In 2022, the 10-year average NWC turnover for commercial contractors was 4.6, while highway construction contractors had an average ratio of 6.7.
Why working capital matters for contractors
While profit is important for long-term business growth, working capital is essential for day-to-day operations. Even profitable contractors can become insolvent if current liabilities come due when the company has insufficient liquidity to satisfy them.
If a construction business is an engine, working capital is the fuel that keeps the engine running. Monitoring working capital helps contractors evaluate liquidity, operational efficiency, and the short-term financial health of the business.
Though largely important for daily operations, working capital can also have an indirect but powerful effect on a contractor’s growth potential. Lending institutions — in particular, those issuing traditional financing products, like a bank loan or line of credit — will assess a contractor’s liquidity to determine their creditworthiness. Healthy working capital can often help businesses access higher loan amounts at cheaper rates.
Learn more: A Contractor's Guide to Financing Options
Working capital and NWC turnover are also important metrics for general contractors in public or commercial construction when bonds are required. Like lenders, surety companies conduct a financial review in the bond underwriting process. Higher levels of working capital and turnover may help a contractor qualify for bonding on larger contracts.
How much working capital do contractors need?
There is no specific amount of working capital that is considered “healthy” for all contractors. In a perfect world, a contractor’s short-term assets would equal short-term liabilities.
“It is important to remember that the optimum amount of working capital theoretically would be zero!” Fred Shelton, Jr. writes in the Journal of Construction Accounting and Taxation. “If a company could structure its finances so that the liquidity risk were somehow reduced to zero, there would be no need for working capital.”
However, operating without any working capital would require a situation with near-instantaneous payments, just-in-time inventory management, and zero financial risk. In reality, construction is an incredibly risky industry. Contractors need a healthy amount of working capital just to be able to survive.
To determine working capital needs, the company will need to determine how quickly their short-term assets and liabilities turn over — and whether the amount of working capital is sufficient to cover any gap between them.
Best practices to increase working capital
Ultimately, there are only two ways for contractors to increase working capital: Grow their short-term assets, or reduce their short-term liabilities.
1. Shorten billing & collection cycles
Until a contractor generates an invoice or payment application on a project, they are only accumulating liabilities on the job, thus reducing working capital. Progress billing throughout the stages of a project boosts working capital in the short term as accounts receivable grow.
Of course, an increase in accounts receivable does not always correspond with an improvement in cash flow. The longer an account receivable remains open, the higher its carrying costs, and the greater the chance of nonpayment.
2. Finance project expenses
In an earlier example, we saw how loans or other financing doesn’t directly increase working capital, because the increase in short-term assets is offset by an increase in short-term liabilities. However, financing project costs like material purchases can enable contractors to take on more projects – or bigger jobs – than they would have been able to afford. As an added bonus, some suppliers may offer discounts for upfront payments.
This is another example that illustrates the difference between working capital and cash flow. Financing expenses can greatly improve a contractor’s cash flow on a project level, even as their working capital remains unchanged.
3. Use long-term debt strategically
Because long-term debt is not considered in the calculation, it can effectively increase working capital. However, an increase in debt can affect a contractor’s access to traditional financing or surety bonds. Creditors often consider an applicant’s working capital to debt ratio to determine their ability to pay off debt, especially in the event of bankruptcy or liquidation.
4. Sell idle assets
If a contractor has fixed assets — heavy equipment, property, etc. — that are sitting idle for long periods of time, they may opt to sell them to generate working capital.
“A sin worse than having excess resources in working capital, is having excess capacity in fixed assets,” says Fred Shelton, Jr. “If the fixed asset is never used, the return on capital is zero.”
Ryan O'Donnell works at Procore as Senior Product Manager, Financials. He has spent his career working in construction finance -- including roles as Controller & CFO for Terminal Construction Corporation in NYC, AVP of Commercial Real Estate at M&T Bank, and Senior Auditor for Kiewit Infrastructure Group. Ryan earned his MBA in Accounting & Finance from Rutgers University. He lives in New York.View profile
Jonny Finity creates and manages educational content at Procore. In past roles, he worked for residential developers in Virginia and a commercial general contractor in Bar Harbor, Maine. Jonny holds a BBA in Financial Economics from James Madison University. After college, he spent two and a half years as a Peace Corps Volunteer in Kenya. He lives in New Orleans.View profile
Ron Benoza is a Senior Field Readiness Architect at Procore, focusing on Financials & ERP. Previously in his career, he served as Project Accountant for Allen Construction, and AR Supervisor at Mentor Worldwide, LLC. He lives in Santa Barbara, California.
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