Working Capital: It’s Not Just Math

Contractors constantly ask advisors this question: “What do you see out there?” That’s a big question and deserves a big answer. In a highly competitive, fast-paced marketplace that is constantly in flux, contending with the same issues that other industries face, the construction industry also manages to be an industry that is unique in its ability to be innovative.

While each construction company is different in terms of its approach to building, one similarity exists at the core—an entrepreneurial nature. And the one thing all entrepreneurs want to know is: “How am I doing compared to my peers and competition?”

One of the best ways to answer this question is with benchmarks. And one of the most powerful benchmarks for a construction company is working capital. For a user of a contractor’s financial statement, such as a surety and a professional surety agent, working capital is a great indicator of a contractor’s immediate financial prowess.

Asset and Liabilities

Working capital is the difference between a company’s current assets and current liabilities. It is a measurement of the company’s operating efficiency and financial health for the next operating cycle (generally, the next 12 months but could be longer). For a construction company, quite simply put, working capital is the financial capacity to perform on the current backlog.

According to Greg Horne, assistant vice president at Liberty Mutual Surety, the base premise of working capital starts with the question: “How is the construction contractor going to fund the company until the payment requisitions come in?”

Kevin McCann, vice president—surety division, Philadelphia Insurance Companies, adds: “Sureties may look at some components of working capital differently, but ultimately we want to understand the liquidity of the company to keep operations funded for the next year.”

The composition of the balance sheet can start to answer these inquiries but, in practice, working capital is not a pure ratio, especially considering the recent changes in Generally Accepted Accounting Principles’ (GAAP) revenue recognition model (Accounting Standards Codification “ASC” 606: Revenues from Contracts with Customers). As part of those changes, upfront cash outflows (such as bond and mobilization costs), which in the past would have been considered job costs and generated book revenue, need to be analyzed for the potential reclassification as prepaid job costs. By definition, this method would increase working capital but, in reality, does it?

While it does depend on the specific contractor and circumstances surrounding those costs, generally, under ASC 606, if it is determined prepaid expenses are job-centric (that is, can be attributed to a specific job), working capital credit can be extended.

Certain assets, Horne says, are discounted while others are deeply scrutinized in his analysis. Items like inventory and general prepaid expenses are often written down by 50%, which may not be enough in some cases. As time passes between when the CPA completes procedures and analysis and when the surety receives the report, underbillings are “audited” again, this time by the surety.

“We typically want to understand what is causing an underbilling and why the contractor has not been able to bill for these costs, especially if the contractor is deeply into or fully extended on a line of credit,” Horne says.

There will always be items sureties want to get a better understanding of beyond prepaids and underbillings. These revolve around aged and unbilled receivables.

“Regardless of the condition of the market, the surety needs to understand the composition of working capital,” says Barry Shabashkevich, vice president of Sompo International–Surety. “Specifically, how old are the receivables and when will the unbilled receivable turn? What’s the true liquidity?”

That very question leads to the analysis of another ratio, receivable turnover.

Supplementary Information

When analyzing a construction company’s financial statement, Shabashkevich delves into the included supplementary information relevant to the construction industry, such as the schedules of contract receivables, contracts completed and contracts in process. These schedules supplement (no pun intended) the surety’s working capital analysis by providing a starting point to forecast cash receipts on a project-by-project basis and establishing how backlog and the associated gross profit will be recognized over the next operating cycle. In other words, using the supplementary information in conjunction with the current working capital ratio, the surety can forecast “tomorrow’s” level as part of the underwriting purposes.

But the analysis does not end with the numbers. Off-balance sheet, it is also important for the surety to understand the customer that the contractor is working for; specifically, what the customer’s payment habits are in terms of the requisition approval process, turnaround time and whether upfront/mobilization costs can be requisitioned.

“Whom a contractor works for and how that customer pays are important to the process,” Horne says, especially if the customer is new.

External Complications

In April 2020, as part of a larger stimulus package, the federal government implemented the Paycheck Protection Program (PPP) as a measure to counter the financial impact businesses were experiencing as a result of the COVID-19 pandemic. The spirit of the program was to allow companies, meeting certain requirements, to apply for a loan with favorable repayment terms; those companies would have the option to be forgiven the loan, if the monies were used on payroll and related employee benefit expenses. In other words, if used for wages and employee benefit costs, the loan would transform into a grant.

Even though the construction industry, especially in the middle market, was a direct beneficiary of this program, the PPP adds a wrinkle to the working capital equation. As loans were granted, contractors saw an infusion of cash offset by a current and long-term loan payable. At present, the construction industry has had no issue in meeting the utilization requirements for these funds to warrant forgiveness, which means that by the end of 2020, or in early parts of 2021, the PPP loan payable amounts being carried on the contractor’s balance sheet will flow through operations and become a permanent increase to equity, net of income taxes as of the date of this article.

While on the surface this seems like an immediate increase to contractors’ working capital capacity, most credit providers, including sureties, are taking a “wait-and-see approach.” As this is an unprecedented program, which has changed a number of times since its implementation, the conservative approach is to analyze working capital without the PPP, in the instance that the program’s forgiveness guidelines change again or if the loan (or a portion of the loan) is not forgiven and has to be repaid.

The working capital analysis will soon face another complication as ASC 842 Leases is adopted, effective for nonpublic entities on Dec. 15, 2021. The guidance will require all long-term leases to be capitalized on the construction company’s balance sheet. In other words, the contractor will recognize a “right of use asset” similar in nature to property and equipment, offset by a current and long-term obligation under the remaining life of the lease. The key here is the contractor will be reporting a new current liability with no offsetting asset.

As noted by Kevin McCann, this will have an impact as to “how working capital is analyzed.” But there could be some relief, as most sureties will make the connection that there is a current portion of the capitalized lease to consider.

Cash Is King

Users, such as the surety community, including professional surety agents, will rely on the work and opinions of CPAs regarding the financial health of a construction company. It is important that the CPA industry understands how the surety looks at working capital so the CPA industry can design the appropriate procedures around the riskier components of this metric.

No two working capital cases are alike, and the process applied to a general contractor should not be the same for a trade contractor.
One recommendation is to analyze working capital both with and without the under- and overbillings, because underbillings are a current asset that does not add to the contractor’s ability to fund the project, and overbillings are a current liability that do not detract from the contractor’s ability to fund the project.

But in the end, all sureties, other creditors, and advisors to the construction industry share the same sentiment: cash has been, is, and always will be king.