Working capital gives a span shot of a company’s financial health. In fact, it has become a powerful benchmark to evaluate how effectively a construction company is running compared to other competitors. For surety agents or banks, working capital is a great indicator of a contractors’ immediate financial prowess.
In this part, we’ll share the light on working capital definition, how to calculate it, and understand the positive and negative working capital with some special considerations.
What is Working Capital?
Working capital, as known as net working capital (NWC), is the difference between a company’s current assets and current liabilities. In other words, it is the difference between what you own and what you owe.
Working capital is a measurement of a company’s operational efficiency, liquidity, and short-term financial health. For a construction company, it is the financial capacity to perform on the current backlog.
Your current assets are cash or other assets that are expected to be converted to cash within a year or less. Typically, current assets would include:
Down payment from customers
Any other assets that can be converted to cash within one year or less
Your current liabilities are due to be paid to the creditors within a year or less. Examples of current liability include:
Wages due to employees and contractors for work performed but not yet paid
Payments due to vendors or suppliers for materials
Credit card debts
Any other short-term debt obligation payable within one year or less
How to Calculate Working Capital
To calculate working capital, compare the current assets with the current liabilities - specifically, subtract the former with the latter.
Calculating your working capital allows you to determine whether you have sufficient cash to pay your bills in the near term or at the end of the year.
Working capital = Current Assets - Current Liabilities
Positive working capital indicates that you have enough cash on hand to pay your staff and suppliers, buy raw materials, meet your tax obligation, repay any borrowing and It means you are in a strong position to weather any downturn in the construction sector, and more importantly, you are able to invest in future activities and growth. Conversely, negative or low working capital may indicate a risk of distress or default.
That said, too much high working capital isn’t always a good thing. It might indicate that the business is not investing its excess cash or has too much inventory.
Similarly, negative working capital can be a good thing that any company’s current liabilities finance its current assets, as working capital is being generated through the collection of payments and payoff from investments. This approach requires more aggressive and nimble thinking since there’s little cash on hand, you must quickly convert accounts receivable into cash in order to pay off short-term liabilities.
How Working Capital Matters in Construction
A construction company may become insolvent even if it is generating profit. How? By failing to convert adequate levels of current assets relatively quickly to pay its current liabilities. Therefore, working capital is crucial to keep your construction company surviving and growing.
In addition, working capital is a key metric used by banks and surety companies when determining a contractor's creditworthiness or bonding capacity.