Capital capacity is just a fancy way of saying having enough cash around to finance projects ongoing plus projects under consideration. The construction industry is grossly undercapitalized. This, I believe, is the primary risk factor that contractors deal with daily whether they realize it or not. Unlike every other industry in America, construction companies rarely tap the public markets for cheap and plentiful growth capital. For reasons I do not fully understand to this day, we limit our accumulation of capital to earnings we choose to retain rather than spend - and to working capital lines of credit at our banks.

Research confirms that retained earnings and bank lending are sometimes sufficient to sustain a conservative company that is not growing. A company that adds the next job only after completing an ongoing similar job is sustaining but not growing. Few contractors are satisfied with this “no-growth” profile. Most believe that if you are not growing you are going backward. Therefore, construction organizations are always seeking bigger and better jobs to take their company into the future and support the overhead (personnel, equipment, office space, etc.) they have proudly built over the years. This is where so many construction enterprises get into trouble.

Projecting Not Reporting

The underutilized sources and uses of funds, standard part of financial statements, is a critical management tool. Traditionally, contractors have ignored balance sheets and cash flow reports because there is a mistaken belief that these after-the-fact reports cannot help them manage the business into the future.

Most of the failed contractors that I dealt with in the work-out business I ran on behalf of sureties were shocked and surprised when they ran out of money. There rarely was a sudden catastrophic external risk factor that caused their collapse. They simply were unable to finance the cash flow requirements of the projects they had underway, and they had no warning because they did little or no cash flow planning. The calculation of adequate working capital for a contractor engaged in multiple jobs is a sophisticated ongoing financial projection best left to experienced CFOs. The projection is composed of two fluid poles: sources of working capital and uses of working capital.

Sources of Working Capital

For the purposes of this planning tool, I define working capital as the amount of money needed to finance the ongoing business activity of a construction enterprise. The sources I’m talking about are not strictly accounting terms. They are real world observations about what is happening to working capital as a construction company goes about its business, and a prediction of how working capital will be impacted as the business unfolds. The sources are:

1. Cash (or other liquid assets like stocks/bonds etc.) on hand.
2. Unused amount of the “working capital line of credit” at the bank.
3. Amount of the accounts payable credit extended by material vendors and suppliers (usually 30 day).
4. One week’s accumulated but unpaid payroll. (In certain circumstances this could be a two-week sum.)

Uses of Working Capital

1. Total accounts receivable from all projects ongoing. (Cash owed but not paid)
2. Accounts receivable payments in contention. (Cash delayed)
3. Deposits required (Cash paid in advance of billing for it)
4. Capital expenditures. (Cash invested but not billed)
5. Overhead not billed directly to ongoing projects. (Cash expended but not billed.)
6. Tax deposits
7. Payroll funded but not yet billed to projects.
8. Costs in excess of (or prior to) billing.
9. Uncollected retainage (funds from jobs already completed and billed but not collected.)

Ready-Fire-Aim (Neglecting cash flow planning)

The list above is a sample. Next week we will offer a complete schematic of the possible sources and uses that must be calculated on an ongoing basis by the firm’s CFO. The contractors who had suddenly failed and were surprised they had run out of money were competent builders, and intelligent businesspeople. Which is why the question, “How could they suddenly run out of money and not have seen it coming?” has always nagged at me.

Undercapitalized and Overburdened

It took years to discover and verify the answer - Construction companies are severely undercapitalized from the very beginning and, because the industry has gradually assigned to them most of the transactional risk, the deck is stacked against us. It’s a wonder that any of us have made a success of it given the challenges we face.