What Is Working Capital and Why Does It Matter to Contractors?
Working capital generally measures the relationship between a company's current assets and current liabilities.
A simple calculation is:
Current Assets − Current Liabilities = Working Capital
For construction contractors, working capital matters because it helps support the day-to-day financial demands of performing work.
It can influence:
liquidity;
bonding capacity;
banking relationships;
lines of credit;
project capacity; and
the ability to finance growth.
A contractor can be profitable and still experience a working-capital shortage.
That is especially common during rapid growth.
What Are Current Assets?
Current assets generally include assets expected to become cash, be sold, or be consumed within the operating cycle or other applicable current-period criteria.
For a contractor, they may include items such as:
cash;
accounts receivable;
retainage receivable;
contract assets or underbillings;
inventory;
certain prepaid expenses; and
other current assets.
The exact composition depends on the contractor's financial statements.
What Are Current Liabilities?
Current liabilities generally represent obligations expected to be settled within the applicable current period or operating cycle.
They may include:
accounts payable;
accrued payroll;
payroll taxes;
current debt;
accrued expenses;
contract liabilities or overbillings;
current lease obligations; and
other short-term liabilities.
The relationship between current assets and current liabilities provides a basic view of short-term financial capacity.
A Simple Working Capital Example
Suppose a contractor has:
Cash: $750,000
Accounts receivable: $1,400,000
Retainage and other current assets: $350,000
Total current assets: $2,500,000
The contractor also has:
Accounts payable: $900,000
Overbillings and accrued expenses: $450,000
Current debt: $150,000
Total current liabilities: $1,500,000
Working capital is:
$2,500,000 − $1,500,000 = $1,000,000
That $1 million provides a financial cushion for current operating needs.
But the calculation is only the starting point.
Why Does Working Capital Matter So Much in Construction?
Construction businesses often have to spend cash before receiving cash.
A contractor may need to pay:
payroll;
materials;
subcontractors;
equipment;
insurance;
mobilization costs; and
overhead
before the customer pays the related billing.
That timing gap requires working capital.
The larger the projects and backlog, the larger the potential funding need.
Profit Does Not Automatically Create Working Capital
A contractor can show strong accounting profit while cash is tied up in:
receivables;
retainage;
underbillings;
equipment;
or other assets.
For example:
Net income: $800,000
Underbillings: $600,000
Aged receivables: $500,000
Retainage: $400,000
The contractor may be profitable.
But a significant amount of economic value is not yet available as cash.
That can create working-capital pressure.
Rapid Growth Can Consume Working Capital
Growth is one of the most common reasons a profitable contractor experiences liquidity pressure.
Suppose a contractor grows from:
$10 million of annual revenue
to
$18 million.
The larger workload may require:
additional field labor;
more project managers;
larger material purchases;
bigger subcontractor commitments;
additional equipment;
higher insurance;
and greater overhead.
Those cash requirements often occur before the contractor collects the related revenue.
Growth can therefore consume working capital before it generates additional cash.
More Backlog Means More Future Obligations
Backlog represents future opportunity.
It also represents future costs.
A larger backlog may require more:
labor;
materials;
subcontractor capacity;
project management;
equipment; and
cash.
The contractor should evaluate whether its working capital can support the planned workload.
A strong backlog without sufficient capital can become a constraint.
Why Sureties Care About Working Capital
Sureties may evaluate working capital as part of assessing whether a contractor has sufficient financial resources to perform bonded work.
They may consider:
total working capital;
composition of current assets;
quality of receivables;
underbillings;
overbillings;
current debt;
and trends over time.
Working capital is not the only factor affecting bonding capacity.
But it can be an important one.
Related Resource: What Does a Surety Look for in a Contractor's Financial Statements? →
Why Working Capital Can Affect Bonding Capacity
A contractor seeking larger individual or aggregate bonding capacity may need sufficient financial resources to support the additional work.
More bonded work can create more:
payroll;
material purchases;
subcontractor payments;
and project obligations.
A surety may therefore ask whether the contractor's balance sheet has grown along with its backlog.
Related Resource: How Can a Contractor Improve Bonding Capacity? →
Banks Care About Working Capital Too
Banks may review working capital when evaluating:
lines of credit;
borrowing capacity;
loan covenants;
acquisitions;
and general financial condition.
A contractor with good profitability but weak working capital may rely more heavily on borrowing to finance operations.
That can influence lending discussions.
Working Capital and a Line of Credit Are Different
A line of credit can supplement liquidity.
It does not replace working capital.
For example:
Working capital: $500,000
Available line of credit: $1 million
The contractor has access to additional liquidity.
But borrowing against the line also creates:
debt;
interest;
repayment obligations; and
reduced future availability.
A line of credit can be a useful tool.
It should not become a substitute for fixing persistent operating cash-flow problems.
Current Ratio Provides Another Perspective
Another commonly used liquidity measure is the current ratio:
Current Assets ÷ Current Liabilities = Current Ratio
Using the earlier example:
Current assets: $2.5 million
Current liabilities: $1.5 million
Current ratio:
1.67
That means the company has approximately $1.67 of current assets for every $1 of current liabilities.
Working capital and the current ratio measure related concepts, but in different ways.
More Working Capital Is Not Automatically Better
A large working-capital balance can look strong.
But management should understand what it consists of.
For example:
Contractor A has $2 million of working capital primarily supported by:
cash;
current receivables; and
normal operating assets.
Contractor B also has $2 million, but much of it consists of:
old receivables;
large underbillings;
related-party receivables; and
slow-moving balances.
The headline number is the same.
The quality may be very different.
Cash Is Usually the Most Liquid Component
Cash can generally be used immediately to fund:
payroll;
vendors;
subcontractors;
taxes;
debt;
and other obligations.
But even cash needs context.
A contractor may have substantial cash because projects are significantly overbilled.
Some of that cash may be needed to fund future project costs.
Accounts Receivable Need to Be Collectible
Accounts receivable can support working capital.
But only if customers ultimately pay.
Management should monitor:
receivable aging;
customer concentration;
disputes;
rejected billings;
collection history;
and large outstanding balances.
A $500,000 receivable outstanding for 15 days is different from one outstanding for 180 days.
Retainage Can Tie Up Working Capital
Retainage may remain outstanding long after the contractor has incurred the related costs.
That means the contractor may already have paid:
employees;
suppliers;
subcontractors; and
overhead
while still waiting for a portion of the contract payment.
Large retainage balances can consume working capital.
Underbillings Can Consume Working Capital
Underbilling occurs when earned revenue exceeds cumulative billings.
The contractor may have performed the work and incurred the cost without yet billing the customer.
That effectively means the contractor is financing a portion of the project.
Large or growing underbillings can therefore create significant liquidity pressure.
Related Resource: What Is Overbilling vs. Underbilling in Construction? →
Not Every Underbilling Has the Same Quality
An underbilling caused by normal month-end timing may resolve quickly.
An underbilling caused by:
disputed change orders;
customer disagreement;
missing documentation;
or billing restrictions
may take much longer to convert to cash.
Management should understand the underlying reason.
Overbillings Can Support Working Capital—Temporarily
Overbilling occurs when billings exceed earned revenue.
That can improve cash flow because the contractor may collect cash before incurring all of the related future costs.
But overbillings also represent work still to be performed.
A company that spends overbilled cash without preserving enough resources to complete the project can face future liquidity problems.
Accounts Payable Also Affect the Picture
Stretching vendor payments may temporarily preserve cash and working capital.
But it can create other problems.
These may include:
damaged supplier relationships;
reduced credit availability;
subcontractor issues;
late-payment costs;
lien exposure; and
operational disruption.
Working-capital management should not simply mean delaying every payment.
Current Debt Can Reduce Working Capital
The current portion of debt generally increases current liabilities.
That can reduce working capital.
Equipment loans, term debt, and other financing arrangements can therefore affect the contractor's liquidity metrics even when the business remains profitable.
Contractors should understand upcoming debt maturities and payment obligations.
Owner Distributions Can Reduce Working Capital
Distributions reduce cash and equity.
Large owner distributions can therefore weaken:
liquidity;
working capital;
net worth;
and potentially bonding capacity.
Contractors should consider the effect of distributions on the company's future financial needs.
Equipment Purchases Can Consume Cash
Equipment may be necessary for growth and operations.
But a large cash purchase can move resources out of current assets and into long-term assets.
For example:
Cash before equipment purchase: $1.5 million
Cash equipment purchase: $600,000
Cash afterward: $900,000
The company still owns a valuable asset.
But its short-term liquidity has changed materially.
Working Capital Should Be Forecasted, Not Just Measured
The balance-sheet calculation tells management about working capital at a point in time.
Contractors also need to understand where it is heading.
A forecast may incorporate:
expected collections;
upcoming billings;
payroll;
subcontractors;
material commitments;
equipment purchases;
debt payments;
taxes;
owner distributions;
and new project starts.
That allows leadership to see future working-capital pressure before it becomes urgent.
Use a Cash-Flow Forecast With Working Capital
Working capital and cash forecasting answer different but related questions.
Working capital asks:
What short-term financial resources do we have relative to our obligations?
Cash forecasting asks:
When will cash actually enter and leave the business?
Contractors benefit from reviewing both.
WIP Helps Explain Working Capital
WIP can help management understand why working capital is changing.
For example:
Increasing underbillings may explain declining cash.
Increasing overbillings may explain unusually strong cash.
Margin fade may indicate future cash generation will be lower than previously expected.
WIP and the balance sheet should therefore be analyzed together.
Working Capital Can Change Even When Revenue Is Growing
Suppose revenue increases 30%.
That sounds positive.
But during the same period:
receivables increase 50%;
underbillings double;
cash declines;
current debt increases;
and payables rise.
Revenue is growing.
Working capital quality may be deteriorating.
Growth should be evaluated alongside the balance sheet.
How Can Contractors Improve Working Capital?
Contractors may strengthen working capital by improving areas such as:
profitability;
billing speed;
collection speed;
change-order management;
underbilling control;
cash forecasting;
owner distribution planning;
debt structure;
and project selection.
The right strategy depends on why working capital is constrained.
Bill Promptly
One practical improvement is simply billing completed work as soon as contract terms allow.
Billing delays create avoidable financing needs.
Management should monitor:
billing schedules;
missing documentation;
customer approvals;
pending change orders;
and rejected applications for payment.
Collect Faster
Reducing receivable days can convert accounting assets into usable cash.
Contractors can establish processes for:
receivable aging reviews;
collection follow-up;
dispute resolution;
and escalation of overdue accounts.
Strong collection discipline is part of working-capital management.
Resolve Change Orders Quickly
Unresolved change orders can trap both margin and cash.
The contractor may continue funding:
labor;
materials;
subcontractors;
and overhead
while waiting for approval and billing.
Faster documentation and resolution can reduce that pressure.
Protect Job Margins
Profitability ultimately helps build:
cash;
equity;
and working capital.
Repeated margin fade can weaken all three.
Accurate job costing and monthly WIP allow leadership to identify deteriorating jobs earlier.
Coordinate Growth With Capital Needs
Before taking on significantly more work, ask:
How much payroll will this require?
How much material must we purchase?
What are subcontractor payment terms?
When can we bill?
When do we expect to collect?
How much retainage will be held?
Will we need our line of credit?
What is the effect on working capital?
Growth should have a financing plan.
A Simple Growth Example
Suppose a contractor wins a large new project.
During the first 60 days it expects to fund:
Payroll: $400,000
Materials: $500,000
Subcontractors: $600,000
Other project costs: $150,000
Total initial cash requirement:
$1.65 million
If the first meaningful collection does not arrive until day 75, the contractor must finance that gap somehow.
The project can be highly profitable and still create a serious short-term liquidity need.
That is why rapid growth consumes working capital.
Monitor Working Capital Monthly
Working capital should be part of the contractor's monthly financial review.
Management should understand:
current working capital;
change from prior month;
current ratio;
cash;
receivables;
retainage;
underbillings;
overbillings;
payables;
current debt;
and forecasted liquidity.
The trend often matters as much as the current number.
The Bottom Line
Working capital generally reflects the difference between:
current assets
and
current liabilities.
For construction contractors, it helps support the timing gap between spending money on projects and collecting money from customers.
It can influence:
liquidity
bonding
banking
project capacity
and
growth.
A profitable contractor can still experience working-capital pressure when cash is tied up in:
receivables
retainage
underbillings
or
rapidly growing projects.
The objective is not simply to maximize a balance-sheet number.
It is to maintain enough high-quality working capital to support the work the contractor has today—and the work it wants to take on next.
How Bilotta & Company Can Help
Bilotta & Company, CPAs, LLC works with construction contractors on WIP reporting, job costing, financial statement assurance, accounting, tax, cash-flow forecasting, working-capital planning, and financial leadership.
Through our Contractor Compass® Financial Stewardship program, we help contractors connect:
profitability
WIP
billing
collections
cash flow
working capital
and
growth.
Our Financial Stewardship as a Service® rhythm is:
Close → Analyze → Forecast → Decide.
Because understanding working capital today matters.
Understanding what will happen to it as the company grows matters even more.
Related Resource: How Can a Contractor Improve Bonding Capacity? →
Related Resource: What Does a Surety Look for in a Contractor's Financial Statements? →
Visit the Construction Contractor Financial Resource Center →
This article is provided for general educational purposes and should not be considered accounting, tax, legal, bonding, lending, or financial advice for a specific contractor. The classification and treatment of individual assets and liabilities depends on the applicable accounting framework and specific facts and circumstances.