How much working capital do you need to run a building company?
How much cash should you hold in reserve?
…And can you have too much cash in a business?
The obvious answer is, it depends.
It depends on the size of the building company and if you are planning to significantly grow the business over the next five years, or hold your growth at a steady rate just to cover inflation.
However, if we assume you own a residential building company and your growth rate is between 0% - 25% year on year, then there are some basic principles you can easily apply to your building company.
This will ensure it always has enough cash to pay its bills, as and when they become due and payable, as well as having a reserve fund that will see it through even the most extreme downturn the market can throw at you.
It’s not easy to achieve, and both your accountant and your financial advisor may strongly disagree with this advice. However, failing to follow this advice is the reason why 80% of building companies fail every five years.
The first objective for any building company that focuses on new construction is to ensure they always have enough cash to cover the ‘income in advance’ figure, otherwise known in the industry as ‘work in progress.’
Income In Advance
While the term ‘income in advance’ makes it pretty obvious that this figure is a liability and it relates to ‘other people's money’, because we use the term ‘work in progress’ in this industry, a lot of builders, and virtually all accountants assume the figure relates to workflow and as a result, they treat the amount as an asset.
This results in poorly-run, unprofitable building companies appearing solvent when looking at their balance sheet, which is why they are allowed to continue trading by the licensing authorities even though they are nothing more than ponzi schemes.
Calculating work in progress, or ‘income in advance’ every month is critical for every building company, especially for those involved in new construction. However, equally important is ensuring the building company always has enough cash on hand to cover that liability which can exceed $250,000 for a building company with annual sales of just $3 million.
If you calculate your work in progress figure and you do not have enough cash on hand to cover the liability, it probably means you have been pricing your jobs too low and have been attracting the wrong type of clients. The ones that look for the lowest price rather than the ones who are prepared to pay for service and quality.
On the other hand, if you have enough cash to cover your work in progress figure, then congratulations, there is a good chance your building company is solvent which places you ahead of 50% of your competitors!
However, always remember that holding cash to cover your work in progress figure is not to be confused with working capital.
Working capital is the difference between your current assets, such as cash and debtors, and your current liabilities, such as creditors and of course, the work in progress liability.
So if you have $250,000 in the bank and a $250,000 work in progress liability, those two figures effectively cancel each other out leaving you with zero working capital before we factor in other current assets and liabilities.
Which is why step two is to build up the working capital in your building company so that it covers three months of fixed expenses.
This is what separates the top 5% of building companies from the rest because when you have three months working capital to cover all of your fixed expenses, in addition to the cash held in reserve to cover your work in progress figure, you will never worry about cash flow again.
Instead, you’ll always be making longer term decisions. And because you have no cash flow challenges, those decisions are better. Never again will you take on a client against your better judgment because you needed the cash flow.
Never again will you compromise your margin in order to get a deal over the line because you need to feed the machine. And never again will you take on projects outside your niche in order to ‘plug a gap’ and keep the wheels turning.
It won't be easy to achieve, and your accountant will probably advise you against holding reserves on your balance sheet that make your business a juicy target for the lawyers, however, there are ways to structure your reserves in order to keep them protected while still delivering working capital for your business.
Reaching level two is a monumental achievement for the owner of a building company and something that should keep their building company safe and secure for years to come.
But in order to reach level three, your building company needs to be able to withstand a ‘black swan event’. An event so rare it only happens once every hundred years.
Although recently, they appear to be happening with increasing frequency! The global financial crises, the supply chain crises and now, something far worse is forming as a result of rising inflation and the need to increase interest rates in order to contain it.
Only the building companies that prepare for black swan events can look to the future with any degree of confidence right now.
It’s why Apple with their huge cash reserves will be around for years to come while the highly leveraged companies such as airlines and car manufacturers will be looking for bailouts.
More Like Apple, Less Like Evergrande
So, in order to be more like Apple and less like Evergrande, you need to not only have the cash to cover your work in progress liability, you also need to have enough working capital to cover 12 months of fixed expenses.
However, this is when we need to consider the third question raised at the beginning of this article… How much is too much cash to hold in a business?
In some businesses, 12 months of fixed expenses held in cash is exactly what is needed in order for the company to survive a black swan event.
However, for residential building companies, the situation is very different because they have huge amounts of ‘guaranteed’ income from the un-invoiced amount remaining on their current contracts.
This gives residential builders the opportunity to hold 12 months of fixed expense reserves by taking into account the gross profit forecast on their workflow. However, that figure should never exceed nine months of fixed expenses, which means a building company using the level three calculation should never fall below a level two calculation.
In summary, the balance sheet for a professional building company shows strong cash reserves that cover both ‘income received in advance’ and future expenses, while the balance sheet for an average building company reveals a boat and a couple of jet skis!
If you would like to ensure your building company is around for years to come or can be sold as a going concern, then click on the link below and take a look behind the curtain in order to see the templates and tools we are providing to our members.
This video will reveal the industry benchmarks behind the most successful residential building companies in Australia, New Zealand, Canada and the USA.