Working capital is the funds you have available to cover your short-term expenses. In other words, it’s your firm’s operating liquidity.
How Do You Calculate Working Capital?
Working capital is the difference between your current (short-term) assets and current liabilities.
Current assets include cash, accounts receivable, retention receivable, cost and estimated earnings in excess of billings on uncompleted contracts (WIP) and other relatively liquid assets. On the other hand, current liabilities include accounts payable, retention payable, billings in excess of cost and estimated earnings on uncompleted contracts (WIP), accrued payroll, short-term debt (including bank line of credit), income taxes owed, and other short-term obligations.
To calculate your working capital, you must add up your current liabilities, then subtract them from your total current assets:
Current Assets - Current Liabilities = Working Capital
For example, imagine your business has the following current assets:
Cash: $100,000
Accounts receivable: $400,000
Retention receivable: $25,000
Cost in excess of billings: $40,000
That brings your total current assets to $565,000.
Additionally, it has the following liabilities:
Accounts payable: $150,000
Retention payable: $20,000
Billings in excess of costs: $100,000
Accrued payroll: $10,000
Bank line of credit: $50,000
Other Short-term debt: $20,000
Income taxes owed: $15,000
That brings your total current liabilities to $365,000.
Using the formula above: $565,000 - $365,000 = $200,000 working capital.
Rule of Thumb: Bonding Capacity is 10 X working capital.
Bonding capacity: 10 X $200,000 = $2,000,000.
How Do You Increase Working Capital?
There are numerous ways to boost your working capital — and they all come back to lowering your obligations while increasing your current assets. Here are some ways to do so:
Evaluate and cut expenses: By slashing unnecessary expenses and shareholder distributions you immediately gain back cash each month, boosting your working capital.
Refinance high-interest debt: Moving to a lower interest rate and monthly payment boosts cash flows, thus working capital. However, make sure to avoid fees, or you may lose the working capital benefits.
Consider revolving credit: Credit cards and lines offer additional funds you can tap as needed. Just be sure you pay off your balance to avoid interest charges.
Cut operating cycle time: The faster you can deliver your product or service to customers, the quicker you receive payment.
Optimize inventory management: Inventory is a current asset because of the expectation that you’ll sell it soon after acquiring it. Excess inventory, on the other hand, ties up cash and reduces liquidity. Optimize your inventory management to minimize the amount of inventory sitting on shelves.
Why is Working Capital Important?
Working capital is the #1 formula that underwriting uses to calculate bonding capacity.
Working capital on its own isn’t too helpful without effective and efficient working capital management.
You see, working capital is the day-to-day money you have to fulfill your obligations. You can have a significant amount of current assets, but you won’t necessarily be in a secure financial position if you carry a lot of debt.
Working capital provides the ability to fund the front-end costs of a new project before receiving payment of that first billing.
When an existing project is near or at its completion, that is the unfortunate time when business owners realize that a project lost money or the actual gross profit of a project is less than expected. Adequate working capital provides the liquidity for a company to fund unexpected losses without jeopardizing the liquidity of a future job.
There is no guarantee that every project or every year will be profitable. Working capital can address unexpected events.
Understanding the mechanics of how to increase working capital helps you plan for a better tomorrow!
Ted Bartko, is a construction CPA based in Potomac, MD. His skills include construction accounting, related bonding services, and ensuring a company's profitability. For help with construction accounting, contact Ted at 301-922-1112 or ted@tedbartkocpa.com. Ted serves clients with expertise in bonds, financing and credit. Request a free consultation.