Working Capital And The Construction Industry

23Working Capital and theConstruction IndustryFred Shelton, Jr., CPA, MBA, CVAEXECUTIVE SUMMARY An understanding of working capital is crucial to understanding and analyzing the financial position of constructioncontractors. This article provides a basic primer in working capital concepts for the construction contractor.An understanding of workingcapital is crucial to understanding and analyzing the financialposition of construction contractors. The sureties basetheir bonding program to a great extent onthe amount and quality of working capitalavailable to the contractor.Many contractors attempt to benchmark their key ratios to industry standardswithout understanding what the ratios orbenchmarks mean.The questions posed when examiningthis subject are: Why analyze working capital?What is working capital?How does it compare to current ratios?What are the concerns of the surety andthe banker?How much working capital is enough,and how is that determined?Is there such a thing as too much working capital?Is there a consistent manner of computing working capital?How does a company enhance workingcapital?The purpose of this article is to provide abasic primer in working capital conceptsfor the construction contractor.ANALYZING WORKINGCAPITALWhy analyze working capital? Workingcapital, and current ratio analysis, are considered to be measures of liquidity.Liquidity is one of the key financial statement analysis measures. The key financialstatement analysis measures are generallyconsidered to be as follows: ProfitabilityAsset utilization and efficiencyLiquidityCapital structureReturn on invested capitalLiquidity refers to a company’s ability tomeet its short-term obligations. It isimportant that a company have sufficientworking capital or access to funds to meetits short-term obligations.WORKING CAPITALDEFINEDWorking capital is the excess of currentassets over current liabilities. That leadsto the obvious next question as to the definition of assets and liabilities.Assets are defined as:probable future economic benefitsobtained or controlled by a particularJOURNAL OF CONSTRUCTION ACCOUNTING AND TAXATION November/December 2002FRED SHELTON, JR. isManaging Director ofShelton & Company,CPAs, P.C., an accountingand consulting firm locatedin Central Virginia. Thepractice consists almostexclusively of audits andreviews of, and consultingwith, contractors and theirrelated businesses, including assistance with the special tax and financialproblems faced by contractors. Mr. Shelton hastaught courses in accounting and taxation for contractors for the VirginiaSociety of Certified PublicAccountants, and otherprofessional organizations,and has been a frequentguest speaker and lecturerfor various trade and business groups.

24WORKING CAPITALentity as a result of past transactionsor events.50,000 100,000.) One must be very careful in interpreting financial ratios.Liabilities are defined as:probable future sacrifices of economic benefits arising from presentobligations of a particular entity totransfer assets or provide services toother entities in the future as a resultof past transactions or events.The above definitions are according to theFinancial and Accounting Standards Boardpublication issued as Statement ofFinancial Accounting Concepts No. 6titled Elements of Financial Statements.Current in accounting terms does notmean imminent. It refers to the nextaccounting cycle, or next business year.That is usually assumed to be one year formost companies. In other words, currentassets are those that can reasonably beexpected to be realized in cash, or eithersold, or consumed, in the accounting cycle.CURRENT RATIOThe current ratio is computed by dividingcurrent assets by current liabilities and isthen expressed in mathematical terms.Working capital, by contrast, isexpressed as an absolute dollar amount.Both concepts are measurements or analysis of the same components of a balancesheet.There is a mathematical oddity thatoccurs when comparing working capitaland current ratio. One can improve thecurrent ratio without changing the working capital.For instance, assume a company hascurrent assets of 200,000 and current liabilities of 100,000. This would result in aworking capital of 100,000 ( 200,000100,000 100,000) and a current ratio oftwo to one ( 200,000 divided by100,000 2).By paying 50,000 on liabilities, thecurrent ratio would change from two toone to three to one. Working capital wouldremain at 100,000. ( 150,000-SURETIES AND BANKSIn the soft market of the 1990s, it wasassumed that a contractor could obtain bidand performance bonds for almost anyproject. Also, credit lines and other debtwere easily obtained from banks.After the recession of last year, and postSeptember 11th, the market has tightened. Sureties and lending institutionshave instituted greater scrutiny of the keyfinancial indicators of construction contractors. Of course, the current ratio andworking capital are not the only financialindicators examined, but they haveassumed a greater importance.The sureties have a unique way ofcomputing working capital. As part oftheir analysis, they will eliminate someitems and add some items not consideredby the accounting profession to be inaccordance with generally acceptedaccounting principles.Those items adjusted by the surety andnot credited for the contractor are prepaidexpenses, prepaid income taxes, and anything else that does not provide funds tomeet a payroll. All of those items are subtracted from current assets before computing available working capital.However, sureties will often allow onehalf of the value of inventory, unless theinventory has been purchased for specificconstruction projects.On the positive side, there are someitems included by the surety but not normally included in working capital undertraditional analysis. Those items are cashsurrender value of life insurance, and marketable equitable securities not held forsale.It is also important to keep workingcapital clear of bank liens. If the bankuses receivables and inventory as security,then the surety will not credit thoseamounts towards working capital.JOURNAL OF CONSTRUCTION ACCOUNTING AND TAXATION November/December 2002

WORKING CAPITALExhibit 1Sample Income Statement and Working Capital DataAssume the following simplified income statement of a sample electrical contractor:Electrical Contractor—Income Statement(data in thousands)RevenuesCost of Revenues (includes 250 depreciation and 1,000 labor)Gross ProfitG&A ExpenseOperating IncomeLess: Income TaxesNet Income 5,0004,25075054520572 133Assume the following balance sheet working capital data:Electrical Contractor- Working Capital Data(data in thousands)CashReceivablesEnding inventoryUnderbillingsPrepaidsTotal Current AssetsCurrent portion of long-term debtOverbillingsPayablesAccrualsTotal Current AssetsWorking CapitalOPTIMUM WORKINGCAPITALIf one consults accounting textbooks, onewill often find a statement that a currentratio of two to one is excellent. TheConstruction Financial ManagersAssociation survey for all participatingcompanies for the last year available, 2001,shows a current ratio of slightly over oneto one (1.3 to 1).It is important to remember that theoptimum amount of working capital theoretically would be zero! If a company could 2060060505735(50)(50)(350)(20)(470) 265structure its finances so that the liquidityrisk were somehow reduced to zero, therewould be no need for working capital.Funds invested in working capital arenot as productive as operating assets.If you can minimize working capital,you can maximize cash flow. The availablecash can then be more profitably investedin the business.However, the fact remains that workingcapital is needed to meet current obligations. So the question becomes, howmuch working capital does a businessneed to account for the liquidity risk, butJOURNAL OF CONSTRUCTION ACCOUNTING AND TAXATION November/December 200225

26WORKING CAPITALExhibit 2Computation of Asset Conversion DaysElectrical Contractor—Asset Conversion Days(data in thousands)Receivable turnover SalesequalsDays44divided byMod Costof Sales3,000equalsDays4divided byMod Costof Sales3,000equalsDays(26)divided by5,000Inventory turnover daysBalance60Payable turnover daysBalance(350)Net asset conversion daysat the same time, not invest excess fundsin the process?COMPUTATION OFMINIMUM WORKINGCAPITAL REQUIREDThere are some simple computations tobe made to determine the requiredamount of working capital. Exhibit 1 presents a simplified income statement andbalance sheet working capital data of asample electrical contractor.Primarily, working capital requirementsof a company depend on its net asset conversion days. Or, phrasing it another way,determining its net trade cycle in days.They both mean the same thing. How longdoes it take to convert receivables andinventory, less trade payables, into cash?Asset Conversion Days Receivableturnover days (net of over/underbillings), plus inventory turnover days,minus payable turnover daysExhibit 2 presents a computation ofasset conversion days. Note that the costof revenues was adjusted to removedepreciation and labor. This is done23because depreciation and labor costs arenot reflected in the trade accounts payablebalances.If the daily sales (annual sales of 5,000divided by 365) are 13.7, then therequired working capital would be 315( 13.7 daily sales X 23 days). It appearsthat the company is not quite at the minimum working capital level required.As a reasonableness check to our calculations, we can compare to a hypotheticalbond program.Many sureties will often grant a bondedprogram of ten to twenty times working capital. Therefore 265 working capital times 15would produce a bonded program of 3,975,or close to 4,000 in revenues. Twenty timesworking capital would produce a program of 5,300. Since twenty times working capital isthe maximum available, and not the norm,this surety “rule of thumb” indicates that thecompany is borderline, but has insufficientworking capital.IMPROVING WORKINGCAPITAL POSITIONSome look for a magic bullet with whichto solve problems. They think there mustJOURNAL OF CONSTRUCTION ACCOUNTING AND TAXATION November/December 2002