Cash flow, working capital and the cash conversion cycle

Contractors rarely fail because they are unprofitable on paper; they fail because they run out of cash. Lesson 1 showed how growth can absorb a year's profit; Lesson 3 showed the working capital lines on Kestrel's cash flow statement. This lesson looks at cash management at the company level: what working capital is made of, how long cash is tied up in the operating cycle, how to forecast company cash over the next weeks and months, and what levers a contractor has to improve its position. CON-310 Lesson 11 covered the cash flow curve of a single project and the payment law that governs it; here we add up all the projects and the overhead to see the firm's position.

Working capital and its parts

Working capital is current assets minus current liabilities. For a contractor, it is both a measure of liquidity and the single most important figure for sureties and lenders, because it is the cushion that funds payroll and suppliers while the firm waits to be paid, and the first line of defence if a job goes wrong.

Expressing each item in days makes it easier to see what drives working capital. Kestrel's receivables represent about 43 days of revenue; if collection slowed to 55 days, about $1.9 million more cash would be tied up. Holdback ties up another 17 days. On the other side, Kestrel holds about 40 days of its costs in payables and 14 days in holdback owed to its subcontractors, and its overbillings provide 14 days of revenue in advance.

The cash conversion cycle

The cash conversion cycle measures how long a firm's cash is tied up between paying for its costs and collecting from customers. For a manufacturer, it is days of inventory plus days of receivables minus days of payables. Contractors hold little inventory, so a construction version uses receivables, holdback and underbillings on the asset side and payables, holdback payable and overbillings on the liability side.

In this version, DSO is days of receivables excluding holdback, DHR days of holdback receivable, DUB days of underbillings, DPO days of payables, DHP days of holdback payable and DOB days of overbillings. Receivable-side items are measured against revenue and payable-side items against contract cost.

revenue, cost = 58_400_000, 53_440_000
d_rev, d_cost = revenue / 365, cost / 365
assets = {"receivables": 6_900_000, "holdback receivable": 2_700_000, "underbillings": 1_150_000}
liabs = {"payables": 5_800_000, "holdback payable": 2_100_000}
overbillings = 2_250_000
tied = sum(v / d_rev for v in assets.values())
funded = sum(v / d_cost for v in liabs.values()) + overbillings / d_rev
for k, v in assets.items():
    print(f"{k:22} {v / d_rev:5.1f} days")
for k, v in liabs.items():
    print(f"{k:22} {v / d_cost:5.1f} days")
print(f"{'overbillings':22} {overbillings / d_rev:5.1f} days")
print(f"Cash conversion cycle: {tied - funded:5.1f} days")

receivables             43.1 days
holdback receivable     16.9 days
underbillings            7.2 days
payables                39.6 days
holdback payable        14.3 days
overbillings            14.1 days
Cash conversion cycle:  -0.8 days

Kestrel's cycle is close to zero: its subcontractors, suppliers and overbillings finance nearly all of the cash tied up in receivables, holdback and underbillings. That is typical of a general contractor that subcontracts most of its work and pays subcontractors after it is paid. A specialty trade contractor that self-performs most of its work pays weekly wages and has fewer subcontractors to lean on, so its cycle is usually much longer, perhaps 40 to 70 days, and its need for working capital per dollar of revenue is higher.

A near-zero cycle is not a reason for complacency. It depends on paying subcontractors only after the owner pays, which payment legislation increasingly restricts (CON-310 Lesson 11), and on keeping overbillings, which unwind as jobs finish. If a large owner pays slowly, the general contractor may still have to pay its subcontractors within statutory deadlines, and the cycle lengthens quickly.

Forecasting company cash

A contractor should forecast its cash flow, not just its profit. Two horizons are common. A thirteen-week forecast, updated weekly, lists expected receipts and payments by week and shows when the line of credit will be needed. A twelve-month forecast, updated monthly, rolls up the project cash flows from each job's schedule and billing plan, adds expected new work from the backlog and pipeline, and deducts overhead, equipment purchases, debt payments, taxes and dividends.

import random
random.seed(8)
# 13-week company cash forecast (illustrative, in thousands)
opening = 2_850
receipts = [1_150, 980, 1_420, 860, 1_300, 1_050, 1_390, 900, 1_240, 1_120, 1_460, 870, 1_310]
payroll = [210, 0, 215, 0, 220, 0, 225, 0, 225, 0, 230, 0, 230]       # bi-weekly
subs_suppliers = [880, 1_150, 760, 1_240, 820, 1_180, 790, 1_260, 840, 1_200, 860, 1_250, 900]
overhead = [65] * 13
other = [0, 0, 180, 0, 0, 0, 95, 0, 0, 350, 0, 0, 0]    # loan payment, equipment, tax payment
cash, low = opening, (0, opening)
for wk in range(13):
    cash += receipts[wk] - payroll[wk] - subs_suppliers[wk] - overhead[wk] - other[wk]
    if cash < low[1]: low = (wk + 1, cash)
    print(f"Week {wk + 1:>2}: closing cash {cash:>6,}")
print(f"Lowest point: week {low[0]} at {low[1]:,} thousand")

Week  1: closing cash  2,845
Week  2: closing cash  2,610
Week  3: closing cash  2,810
Week  4: closing cash  2,365
Week  5: closing cash  2,560
Week  6: closing cash  2,365
Week  7: closing cash  2,580
Week  8: closing cash  2,155
Week  9: closing cash  2,265
Week 10: closing cash  1,770
Week 11: closing cash  2,075
Week 12: closing cash  1,630
Week 13: closing cash  1,745
Lowest point: week 12 at 1,630 thousand

The forecast shows cash drifting down over the quarter, with a low point late in the period after a tax instalment and a large subcontractor payment cycle. It does not go negative, but the cushion thins. Management can see this weeks ahead and decide whether to draw on the line of credit, chase a slow receivable, delay an equipment purchase or time a dividend differently. The point of a forecast is not accuracy to the dollar but early warning.

Levers on the receivables side

The fastest way to improve a contractor's cash is to bill fully and promptly and to collect what is billed. Many contractors leave cash on the table through slow or incomplete billing.

Levers on the payables side

On the other side, a contractor can manage when it pays, within the law and its contracts. Paying subcontractors and suppliers on agreed terms, not early, preserves cash; paying them late damages relationships, risks liens and statutory penalties, and is noticed by sureties and credit agencies. Early-payment discounts from suppliers are often worth taking: a 2 % discount for paying in 10 days instead of 30 is equivalent to an annual return of over 36 %, far more than the cost of the line of credit.

Pay-when-paid and pay-if-paid clauses, which tie a subcontractor's payment to the contractor's receipt of payment, are restricted in many provinces by prompt payment legislation, which sets fixed periods for payment down the chain once the owner pays or fails to dispute a proper invoice. Contractors cannot rely on such clauses to stretch payables; CON-220 and CON-310 cover the details.

Growth and working capital

Because each dollar of revenue ties up some working capital, a growing contractor needs more working capital each year. The amount depends on the cash conversion cycle and the firm's mix of self-performed and subcontracted work. A useful planning question is how fast the firm can grow on its own profits without borrowing more or weakening its ratios. If the firm keeps its working capital at a fixed percentage of revenue, its sustainable growth rate is roughly its retained profit divided by the working capital it needs per dollar of revenue.

revenue, wc = 58_400_000, 2_450_000
wc_ratio = wc / revenue                      # working capital per revenue dollar
net_margin, payout = 0.021, 0.28             # after-tax margin and dividend share
retained = revenue * net_margin * (1 - payout)
# Assume equipment spending absorbs about 40 % of retained profit
available_for_wc = retained * 0.60
growth = available_for_wc / wc_ratio
print(f"Working capital per revenue dollar: {wc_ratio:.3f}")
print(f"Retained profit: {retained:,.0f}; available for working capital: {available_for_wc:,.0f}")
print(f"Revenue growth supportable at the same ratio: {growth:,.0f} "
      f"({growth / revenue:.1%})")

Working capital per revenue dollar: 0.042
Retained profit: 883,008; available for working capital: 529,805
Revenue growth supportable at the same ratio: 12,628,816 (21.6%)

On these assumptions, Kestrel can grow by about $13 million, or roughly 22 %, next year while keeping working capital at its current share of revenue. Its plan for $64 million is within that limit. A plan to reach $80 million would require more equity, more borrowing or a lower working capital ratio, and its surety would want to discuss how it would be financed and managed.

Liquidity measures

Beyond working capital, analysts use a few simple liquidity ratios. Each has a construction twist.

Ratios are only signals, and they move with the business cycle and with the timing of the year-end. A contractor that collects a large holdback the week before year-end looks more liquid than one that collects it the week after. Lesson 12 discusses benchmarks and how to read trends rather than single values.