For most contractors bonding is imperative for a lot of jobs and especially larger jobs. Bonding provides assurance to the project owner that the contractor will perform the work and pay their subcontractors, laborers and material suppliers. Bonds are a risk transfer mechanism where the bonding agent (surety) guarantees to the project owner that the contractor will perform the contract as specified. One of the financial metric that bonding agents look at when bonding a contractor is working capital. Below, I will discuss why working capital is important for contractors and how a contractor can increase their working capital.
Working capital is the capital a business uses in its day-to-day operations and is calculated as current assets minus current liabilities. It measures a company’s ability to pay off its current liabilities with its current assets and is a way to measure a company’s short-term financial health, operational efficiency and liquidity. Healthy working capital indicates a contractor’s ability to service the short-term financial obligations and has an effect on cash flow. Surety’s usually require a working capital position of 5% to 10% depending on the size of the contractor. For example, if a contractor is looking for a $5,000,000 bonding capacity, the surety would need to see $500,000 to $250,000 in working capital. Surety underwriters are also more likely to offer discounts on surety bond costs if a company has adequate working capital. Working capital also is needed for contractors that are looking to grow and expand as you will need the working capital to fund production.
Working capital guarantees that the day-to-day operations of your business runs smoothly. In order to increase the strength of your working capital, a company should do the following:
- Increase collections of receivables
- The company can increase collections of receivables by incentivizing customers to pay early or on time. Company’s can incentivize clients to pay early by providing payment terms that provide a discount for paying early such as possibly a 2/10 net 30 which is the company would provide a 2% discount if the owner pays within 10 days otherwise the total amount is due in 30 days. Offering a discount gets money in the door faster and a company doesn’t have to spend resources trying to collect the money.
- Pay debt obligations on time
- Paying debt obligations on time ensures that a company doesn’t incur additional penalties and interest which drags down cash.
- Choose vendors and subcontractors that offer discounts
- Discounts from vendors are another great way to reduce payables and save some cash.
- Analyze general and administrative costs
- Determining if costs can be reduced will assist the company from spending wastefully and by eliminating or reducing certain expense, the company will have more liquidity for working capital.
- Analyze and identify other ways to increase working capital
- Working capital can be improved by earning higher net profits, maintaining fixed assets so new assets don’t have to be bought or selling fixed assets that are no longer needed or useful in the operations of the company. Also, if a company has inventory on hand, making sure that inventory is not obsolete and not holding excess inventory will assist in a company increasing its liquidity position.
Somerset’s Construction Team has helped many clients with analyzing their working capital and increasing their bonding capacity. Please contact us at 317-472-2200 or if you would like assistance with increasing your working capital position.