The Working Capital Cycle

Last month, we defined working capital (WC) as a measure of liquidity, efficiency and general financial health, easily calculated by subtracting current assets from current liabilities on your most recent balance sheet. The concept of the WC cycle represents the time it takes to convert assets and liabilities into the cash that flows through the whole of your electrical contracting business.

Within the cycle, cash is absorbed, or used, by inventory (items always kept in stock and materials assigned to work in progress) and accounts receivable (customers owing you money). Sources of cash are accounts payable (from your suppliers and other creditors), loans (from banks or private sources) and equity (the difference between the value of your assets and your liabilities or what you own outright). These five numbers are also easily located on your balance sheet.

Every time you are awarded a new project, the cycle gains cash inputs from invoicing and collection activities and loses cash sent out to pay for overhead and direct costs. Cash that is received and not spent recirculates as it is reinvested into maintaining and expanding the assets of the business or is withdrawn by owners as distributed return on their investment.

A faster cycle increases cash, unless bottlenecks are created by periods of slow sales, a balloon payment on a loan, uncollectable receivables, or uninsured losses that drain cash. Even a failure to monitor WC creates slippage over time that eventually stalls growth and devastates profit.

Since WC is the best source of surplus cash to generate profits at the lowest risk, the credit you extend to customers is just as critical to the financial health of your business as the terms you negotiate with your bank and your suppliers. Allowing informal extensions of payment terms to 90–120 days or failing to reduce retainage at the earliest opportunity are common oversights in larger companies. Smaller electrical contractors (those with less than $2 million in annual sales) have been shown to manage the collection of receivables more vigorously, and this often translates into higher profit percentages. As revenue approaches $20 million, however, profit percentages slip and collection periods lengthen, but the slippage may not be as noticeable because the net profit line of the income statement shows a higher dollar total even though the percentage of profit is eroding.

Contractors are often unaware of the connection between WC and financial health because WC isn’t part of the income statement. You probably focus on performance measures—such as earnings before interest, taxes, depreciation and amortization (EBITDA) or earnings per share—that don’t directly reflect the changes in WC. Because profit and cash flow work together, it is important to make WC more visible by including it as a performance measure throughout your company.

Unfortunately, this can result in shortsighted decisions, such as delaying payments to suppliers or cutting inventory levels too low, which negatively affect vendor relationships and prevent on-time completion of projects. Therefore, analyze your supply chain before rewriting your procedures. Track your level of purchasing with each supplier, and ensure the same pricing, terms and discounts are applied to all of your purchase orders. What are the consequences of pressuring suppliers to warehouse bulk purchases, versus maintaining higher inventory levels that cost less and cycle more rapidly through to your jobs?

Inventory levels may be too high, tying up cash and reducing liquidity as the WC cycle runs more slowly. Consider ways to more precisely predict the optimal level of parts for your maintenance contracts without risking lower satisfaction levels among customers who don’t receive prompt service. Calculate the costs of inventory storage, management and handling versus wasted time awaiting late shipments. Do a real-time count of your inventory at least annually, not only to verify accuracy, but also to determine whether you have adequate controls in place to prevent theft.

Are there errors or duplications in your payables and receivables systems? Are your loans properly structured, your lender relationships stagnant, or your project choices inappropriate for the overall skill set of your workforce? This process can reveal more potential for improvement than you thought possible.

Ultimately, your goal is to create shorter cycle times that increase levels of cash faster. Robust WC levels can equal several months’ worth of sales revenue, and even small contractors can free up tens or hundreds of thousands of dollars of ready cash in as little as 60–90 days, without increasing sales or reducing costs.

Next month, we’ll look at key WC ratios to help you measure how well your company is generating the extra cash to reinvest in your employees, facilities or withdraw to support the lifestyle you deserve in exchange for stress of owning your own electrical contracting business.

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