If you haven't figured out the topic of this article, yet, I'll give you a hint, it's about working capital.
What is working capital?
Look up the meaning of working capital and you'll find dozens of definitions.
Working capital is your current assets minus your current liabilities. It's a measurement of your ability to cover your short term obligations.
Why does it matter?
To complete a project, you'll need to pay costs such as labor, material, subcontractor costs, etc., right? All these items flow through your current liabilities at one point either accounts payable or payroll liabilities. In addition, you have note payments to make on financed equipment.
Now what do you need to pay the costs listed above? CASH! If you don't have enough cash you better have current receivables that will be collected within 30 to 45 days to satisfy those obligations. So as you can imagine, having more cash and receivables than payables and other short term liabilities is a good thing. You're in a better position to meet project expectations.
I have provided the simplest form of current assets and current liabilities below in this example.
Three working capital calculations from three different contractors. What I've heard from my underwriter friends and others is that under/overbillings may be included or excluded in the calculation of working capital. From my understanding, that's based on your historical ability to accurately estimate gross profit on jobs. If you're bad at estimating, it's likely that'll get thrown out or discounted. For illustration purposes, I've included two different calculations.
Now, which one of the contractors do you think is in a better position?
Contractor 1! That's right! Contractor 1 has more than enough current assets to cover upcoming liabilities. The underwriters see this as less risky because they have some comfort that the contractor is on course to complete the projects without intervention.
Which one worse off?
Contractor 2! Contractor 2 may run into some issues up ahead. There's a lot of pressure on those receivables being collectible at a time like this. Cash is low and the next best thing is that receivable balance. What's likely to happen is that this contractor will draw on their line of credit to satisfy current liabilities, which means even more pressure as this increases your current liabilities as well.
Now just because Contractor 2 has negative working capital doesn't mean their doomed. They could very well finish on time and on budget, however, the odds are stacked against them.
Working capital is one of the best measurements for contractor success, so keep a close eye on it!