Insight Working Capital Management Feature

Capital Management – Part 4: Financial Capacity

Capital Management 

Part 4

Financial Capacity

 

When Babe Ruth was asked how he used to hit his way out of a batting slump, he replied, “I remembered to keep my eye on the ball.”

 

This series of blogs on capital management are intended to be a reminder to construction professionals to “keep their eye on the ball”. The dramatic sudden degrading of the economy in general, and the construction industry in particular, is putting many small and midsize construction enterprises at risk. Like Babe Ruth, it is time for us to get back to basics and manage the things we can control.

 

Financial Capacity

 

Consider the concept of financial capacity. Financial capacity is a key evaluation area that uses certain balance sheet ratios to determine the cause of problems and, of course, to hopefully prevent them.

 

Two financial capacity measures are:

  1. Revenue to working capital ratio (revenue divided by working capital).
  2. Revenue to equity (revenue divided by shareholders’ equity).

 

These two ratios behave similarly, though the working capital ratio is more volatile and potentially more useful for most management.

 

Revenue to Working Capital

 

One of the most critical issues top management faces during a downturn is deciding how much work to do. If the company takes on too much work where the revenue is high compared to working capital, there will usually be deterioration in liquidity measures, and leverage will increase. When the top line is grown in a determination to get a bigger piece of a shrinking market, all of the components in the company are working harder and are at greater risk of breaking down. Falling liquidity measures and rising leverage are indicators that risk of financial stress is increasing. The increasing revenue to working capital ratio indicates the cause which is, of course, rapid top line growth.

 

For Example

 

If a company’s annual revenue is $5, 000,000 and the working capital at the end of the year is $250,000, the revenue to working capital ratio is 20 to 1. If the firm is doing ten or twelve projects a year and the average job takes plus or minus four months to complete (fairly typical for a trade contractor) the annual work turnover is about three times. In this scenario the target revenue to working capital ratio would be 30 to 1. Anything above this ratio, (e.g. 50 to 1) suggests that the company is very likely stressing its resources and needs to slow down or bring in additional working capital.

 

The Norm

 

Each contractor should determine what the “normal” or “typical” target revenue to working capital ratio is for their company. The most effective place to be in a financial sense is below the revenue to working capital target, but not too far below. If you find your company actually working far below your target revenue to working capital ratio, you are not utilizing capital efficiently and should consider other productive ways of putting it to use.

 

Day to Day Application

 

The first impulse in a shrinking construction market is to compete aggressively for the business that remains. It is hard to resist trying to maintain size. I can only suggest that you take Babe Ruth’s advice and keep your eye on the ball. Watch the revenue to working capital ratio carefully to prevent putting your company under too much stress as you work to get through this latest market cycle. This simple management strategy can help towards prospering through this market and not just surviving the pandemic.

 

Chart A Careful Course

 

Navigating a small or midsize construction enterprise through the rough waters of this sudden market interruption will take some careful management and thoughtful insight. Simply chasing a bigger slice of a smaller pie will not do it. I suggest reviewing the management skills we have been discussing for the past couple of months and utilize the archive of materials available here on the Simplar site. No one knows your company’s capability better than you so no one can chart your company’s safest course better than you.

 

Always Here to Help

 

We will continue our review of risk aversion techniques as long as our industry is in peril from this pandemic. If you have any questions, or want to be pointed to helpful materials, don’t hesitate to ask on this site.