Working Capital and the Construction Industry

1 23 JOURNAL OF Construction ACCOUNTING AND TAXATION November/December 2002An understanding of workingcapital is crucial to understand-ing and analyzing the financialposition of Construction con-tractors. The sureties basetheir bonding program to a great extent onthe amount and quality of Working capitalavailable to the contractors attempt to bench-mark their key ratios to Industry standardswithout understanding what the ratios orbenchmarks 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?

2 Is there such a thing as too much work-ing Capital ? Is there a consistent manner of comput-ing Working Capital ? How does a company enhance workingcapital?The purpose of this article is to provide abasic primer in Working Capital conceptsfor the Construction WORKINGCAPITALWhy analyze Working Capital ? Workingcapital, and current ratio analysis, are con-sidered to be measures of is one of the key financial state-ment analysis measures. The key financialstatement analysis measures are generallyconsidered to be as follows: Profitability Asset utilization and efficiency Liquidity Capital structure Return on invested capitalLiquidity refers to a company s ability tomeet its short-term obligations.

3 It isimportant that a company have sufficientworking Capital or access to funds to meetits short-term CAPITALDEFINEDW orking Capital is the excess of currentassets over current liabilities. That leadsto the obvious next question as to the def-inition of assets and are defined as:probable future economic benefitsobtained or controlled by a particularWorking 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 SHELTON, JR. isManaging Director ofShelton & Company,CPAs, , an accountingand consulting firm locatedin Central Virginia.

4 Thepractice consists almostexclusively of audits andreviews of, and consultingwith, contractors and theirrelated businesses, includ-ing assistance with the spe-cial tax and financialproblems faced by contrac-tors. Mr. Shelton hastaught courses in account-ing and taxation for con-tractors for the VirginiaSociety of Certified PublicAccountants, and otherprofessional organizations,and has been a frequentguest speaker and lecturerfor various trade and busi-ness CAPITALJOURNAL OF Construction ACCOUNTING AND TAXATION November/December 2002entity as a result of past transactionsor are defined as:probable future sacrifices of eco-nomic benefits arising from presentobligations of a particular entity totransfer assets or provide services toother entities in the future as a resultof past transactions or above definitions are according to theFinancial and Accounting Standards Boardpublication issued as Statement ofFinancial Accounting Concepts No.

5 6titled Elements of Financial in accounting terms does notmean imminent. It refers to the nextaccounting cycle, or next business 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 RATIOThe current ratio is computed by dividingcurrent assets by current liabilities and isthen expressed in mathematical Capital , by contrast, isexpressed as an absolute dollar concepts are measurements or analy-sis of the same components of a is a mathematical oddity thatoccurs when comparing Working capitaland current ratio. One can improve thecurrent ratio without changing the work-ing instance, assume a company hascurrent assets of $200,000 and current lia-bilities of $100,000.

6 This would result in aworking Capital of $100,000 ($200,000-100,000=$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. ($150,000-50,000=$100,000.) One must be very care-ful in interpreting financial 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 the recession of last year, and postSeptember 11th, the market has tight-ened. Sureties and lending institutionshave instituted greater scrutiny of the keyfinancial indicators of Construction con-tractors.

7 Of course, the current ratio andworking Capital are not the only financialindicators examined, but they haveassumed a greater 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 items adjusted by the surety andnot credited for the contractor are prepaidexpenses, prepaid income taxes, and any-thing else that does not provide funds tomeet a payroll. All of those items are sub-tracted from current assets before comput-ing available Working , sureties will often allow one-half of the value of inventory, unless theinventory has been purchased for specificconstruction the positive side, there are someitems included by the surety but not nor-mally included in Working Capital undertraditional analysis.

8 Those items are cashsurrender value of life insurance, and mar-ketable equitable securities not held 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 CAPITAL25 JOURNAL OF Construction ACCOUNTING AND TAXATION November/December 2002 OPTIMUM 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 ( to 1).It is important to remember that theoptimum amount of Working Capital theo-retically would be zero!

9 If a company couldstructure its finances so that the liquidityrisk were somehow reduced to zero, therewould be no need for Working invested in Working Capital arenot as productive as operating you can minimize Working Capital ,you can maximize cash flow. The availablecash can then be more profitably investedin the , the fact remains that workingcapital is needed to meet current obliga-tions. So the question becomes, howmuch Working Capital does a businessneed to account for the liquidity risk, butExhibit 1 Sample Income Statement and Working Capital DataAssume the following simplified income statement of a sample electrical contractor:Electrical Contractor Income Statement(data in thousands)Revenues$5,000 Cost of Revenues (includes 250 depreciation and 1,000 labor)4,250 Gross Profit750G&A Expense545 Operating Income205 Less: Income Taxes72 Net Income$133 Assume the following balance sheet Working Capital data.

10 Electrical Contractor- Working Capital Data(data in thousands)Cash$20 Receivables600 Ending inventory60 Underbillings50 Prepaids5 Total Current Assets735 Current portion of long-term debt(50)Overbillings(50)Payables(350)Acc ruals(20)Total Current Assets(470) Working Capital $26526 Working CAPITALJOURNAL OF Construction ACCOUNTING AND TAXATION November/December 2002at the same time, not invest excess fundsin the process?COMPUTATION OFMINIMUM WORKINGCAPITAL REQUIREDT here are some simple computations tobe made to determine the requiredamount of Working Capital . Exhibit 1 pre-sents a simplified income statement andbalance sheet Working Capital data of asample electrical , Working Capital requirementsof a company depend on its net asset con-version days.