Working capital is the lifeblood of any business. Put simply, it’s the difference between your current assets and your current liabilities. Or put another way the difference between what you own and what you owe.
Working capital can be either positive or negative, and negative working capital doesn’t necessarily mean that your company is heading to the wall.
If you have positive working capital, that means you have cash on hand to pay your staff and suppliers, buy raw materials, meet your tax obligations and repay any borrowing. It also means that you are in a strong position to weather any downturn in the construction sector.
That said, maintaining high levels of working capital requires iron discipline and a relatively cautious approach to investing in business growth, creating a significant opportunity cost. In other words, if you keep your cash on call in a deposit account, then that money isn’t working hard for you.
An alternative view holds that negative working capital can be good: that any company’s current liabilities finance its current assets, as working capital is being generated through collection of payments and payoff from investments.
This approach requires more aggressive and more nimble thinking on the part of the principals: since there is little cash on hand, invoices must be turned into cash quickly and investments must be carefully judged, as putting a foot wrong could leave the business with a huge cash flow problem.
How the construction industry is unique
That’s a general overview, but it’s important to note that the construction sector is different from other industries, due to its unique legal and tax status, distinct credit policies and unusual supply chain.
An efficient construction company should be able to convert its invoices into payments sooner than it must pay its own bills, meaning that a negative working capital approach can lead to faster business growth and higher profits.
As a result, there is a paradoxical situation where the most cash-rich construction companies are the least profitable. But does this mean that caution should be thrown to the wind and cash on hand should automatically be reinvested in business growth? Well, not quite.
Surviving the cash crunch in a low-margin industry
The construction industry is notorious for its relatively low margins and comparatively long collections cycle. This was particularly evident in the collapse of Carillion – a company once thought untouchable.
But how should construction firms manage their cash flow to stay in business and minimise the need to keep huge, unprofitable cash cushions on hand?
1 Manage your working capital closely
Whatever your working capital policy, it’s vital that you have a policy and that you stick to it. If you don’t know how much working capital you have on hand, then you place yourself in a very dangerous position.
Make sure you forecast your assets and liabilities, and your income and expenditure, carefully so that you can identify any upcoming voids and have access to cash to deal with them.
2 Forecast your cash flow whenever you take on new business
Before you commence any new activity, it’s vital that you understand exactly what you will have to spend and when and of course when you get paid. A substantial business win may appear a godsend, but if it’s going to leave a huge hole in your cash flow it could soon put you out of business.
Carefully factor all aspects of a potential business win into your cash flow forecast, and make sure you include a contingency in case the customer is a slow payer. It also goes without saying that should the specifications of the project change, then you need to flow the changes into your forecast.
3 Make your contracts watertight
Anything you do for any customer should be governed by a written contract, which specifies the obligations of both parties. It’s particularly important that the contract clearly specifies any stage payments and also sets out your collections policy.
It’s tempting to be overly flexible at this point to win business, but if you’re taking on a huge project with a single payment at the end and a 60-day deadline, you’re exposing yourself to enormous risk. Look at the big picture and don’t give away more than you can afford.
4 Disseminate information throughout the business
Once you’ve agreed clear terms of business with the client, it’s vital that everybody in the company knows about them and is ready to enforce them. Similarly, it’s vital that information flows the other way.
The project manager may be the first person to know about a change in specifications, but it’s crucial that this data is applied to the cash flow forecast in case it makes a material change to your working capital.
5 Address any issues rapidly
Should the client have any issues or complaints or begin deviating from agreed project milestones and stage payments, this should be addressed at senior management level at the first opportunity.
The last thing you want is to issue an invoice expecting payment within 30 days and find that your client is dragging his heels or worse, refuses to pay as he believes you have underperformed. Make sure everybody in your company knows that resolving problems and collecting payments is their business.
6 Don’t let payment deadlines slide
Once you have agreed payment deadlines with clients, it’s vital that you enforce them. If a customer realises that you request payment in 30 days but will accept it in 60 days without demurring, then 60 days will quickly become the “new normal” for that account and your working capital is negatively affected.
As soon as a payment is delayed, your accounting system should trigger an automatic alert and your accounts team should begin chasing for payment. Another way to stimulate faster payments is to offer a small discount (say, 5%) for payment within a week and enforce statutory interest for late payments.
Alternatively, many construction companies choose to use invoice factoring or discounting: innovative financial solutions that allow you to borrow up to around 85% of the value of your invoices as soon as you issue them, with the balance (less the finance company’s charges) being received when your clients pay. In effect, you get paid immediately, which can transform your cash flow.
7 Keep your costs down
This is the big one. If you can reduce your expenses, you can free up your cash flow without having to win any additional business. Moving your telephony, mobile phone and broadband contract can slash costs, as can relocating to cheaper premises or finding new suppliers of raw materials.
Equally, you don’t need to change suppliers to improve your cash flow. If you can negotiate more favourable (i.e. slower) terms of payment, you can transform your working capital forecast.
Make the right decisions and monitor your cash flow carefully, and you should be able to maintain a negative approach to working capital that will maximise your profits whilst enabling you to stay in business. For sure, this can feel like a high-wire act, but the potential rewards are enormous.
Whilst the construction industry faces its own unique challenges when it comes to payments and deadlines, the general principles behind working capital nonetheless apply. Decide on your strategy and your appetite for risk and then apply iron discipline to ensure you achieve the growth you want and the cash on hand you need.
For further help, read our guide to Working Capital Loans.