Inadequate Working Capital in Construction: Causes and Solutions
by Thomas C Schleifer, Ph.D.
During a recent interview I was asked what percent of the failed construction firms that I worked with had simply run out of money. My answer was, 100%. What's more, they were all surprised that they ran out of funds. These contractors were not startups who didn't know what they were doing. Most were successful contractors who had been in business for many years. The more important industry question is of course, how could this happen?
Inadequate Working Capital
The construction industry's financial foundation rests on a chronic shortage of working capital. Inadequate working capital is a fact of contracting life, almost an essential part of the business model. Why does the construction business model rest on financial quicksand? Let's take a look at how the model evolved and how closely each step might resemble your business.
- Small Startups - Almost all construction companies begin as small closely held businesses. Relatively little capital is invested at start-up.
- Family-Owned Resistance - Closely held family businesses resist giving up control to outside investors so capital needed for growth during the initial growth spurt is limited to internally generated funds.
- Constant Job Acquisition - The day-to-day business of contracting is the acquisition of one new job after another. This constant growth requires abundant working capital.
- Slim Profit Margins - Because the contract acquisition model is based on multiple forms of bid processes, profit margins are slimmer than all other mature American industries.
- Limited Growth Capital - Slim profit margins produce inadequate capital for "growth" needs. The small business owner and the company are virtually identical. Rarely do contractors retain substantial earnings on the company's balance sheet.
- Inaccessible Equity Markets: Public equity markets are rarely accessible for growth capital.
- Reinvestment in Fixed Assets - The remaining contractor earnings are reinvested in fixed assets and not left languishing in liquid form on the balance sheet to be used for working capital.
- Chronic Working Capital Shortage - Because of the resulting chronic shortage of adequate working capital, all growth represents substantial risk for contractors.
Putting Out Fires
Most contractors I have worked with over the years managed cash flow through a process of putting out fires. Few, if any, ever had an advanced cash flow management plan that avoided the perennial unexpected cash shortages. Common short-term 'strategies' I've seen include:
- Borrowing from Other Jobs: Using funds from one project to finance another.
- Extending Supplier Payments: Delaying supplier payments beyond 30 days.
- Front-Loading: Billing early on new projects to cover previous ones.
- Last-Minute Bank Requests: Seeking increased working capital facilities at the last minute.
- Short-Term Loans: Borrowing from personal connections for immediate needs.
The Importance of Cash Flow Planning
Inadequate working capital is the highest risk factor in the contracting business, yet few contractors ever devise a cash flow plan in advance and make go/no-go decisions based on their ability to finance additional work. An effective cash flow plan is a highly complex, professional, ongoing financial projection based on your company's history of:
Collecting Progress Payments: Understanding your company’s payment collection patterns.
Supplier Cooperation: Establishing favorable terms with suppliers.
Working Capital Lines of Credit: Ensuring adequate credit facilities.
Proper Use of Retained Earnings: Strategically utilizing retained earnings for growth.
Crafting and Utilizing a Cash Flow Plan
- Monthly Financial Reports - An updated cash flow plan should be a required monthly financial report prepared by your CFO. The purpose of the plan is to predict cash flow needs in advance and to decide if your current cash flow position will be adequate to take on new contracts under consideration. Most contractors believe that there are too many unpredictable variables in construction industry cash flow and that any static plan is rendered inaccurate the day it is put together. That's why most don't bother writing a thorough cash flow plan.
- Dynamic Adjustments - Effective cash flow plans are fluid documents that are adjusted in real time as circumstances change.
- Professional Management - The ability to craft a baseline from the cash flow history of the company, to factor in real time variables, and to estimate adequacy when multiple simultaneous jobs are utilizing available cash must be left to financial professionals. "Guestimates" will result in surprises and, ultimately, put you out of business.
Conclusion Inadequate working capital is a significant risk in the construction industry. By understanding its causes and implementing a comprehensive cash flow plan, contractors can navigate financial challenges and ensure long-term stability.
Dr. Schleifer joined the construction industry at age 16 and has more than 50 years of contracting and consulting experience. He holds a B.S., M.S., and Ph.D. in construction management. Dr. Schleifer’s experience includes serving as foreman, field superintendent, project manager, and vice president of a construction company. To receive Dr. Schleifer's free Weekly Construction Messages, ask questions, or make comments contact: tom@schleifer.com.
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