Will Abberger, EA (Enrolled Agent), MBA (Master of Business Administration) — The Contractor's Bookkeeper
So, let's look at capitalization. How much working capital does a contractor need? The simple answer is "about 10% of your annual volume." But to understand this well, we'll need to dig into a few financial measures.
Working capital is the difference between current assets and current liabilities.
Current assets are any/all assets that are cash, or expected to be converted into cash, during the year. This would include cash, receivables and inventory. We expect to turn our receivables into cash by collecting. We expect our inventory to be used on jobs, then billed for, and then collected.
Current liabilities are items we expect to pay cash for during the year. They include the current portion of notes payable and accounts payable to vendors/suppliers/subcontractors.
Working capital turnover is your annual revenue divided by your working capital.
In the construction industry, there is a definite relationship between profitability and working capital turnover. The most profitable contractors have a working capital turnover between eight (8) and fifteen (15) times.
If you find yourself always short on cash, you're likely undercapitalized. What's your working capital turnover? If it's 15 times or greater, you're in danger of being undercapitalized — you're selling more work than your current working capital can comfortably support, and when that happens, profitability suffers. We end up "chasing cash" instead of "running the business." There are a range of remedies: attract equity capital, establish a line of credit, sell fixed assets, and others. The right move depends on your individual circumstances.