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Many authors and professionals have described working capital as the backbone (Kumar et al, 2014) or lifeblood of every construction business (Ross and Williams, 2013; May, 2015) and have argued that a proper understanding is a vital component to the long-term success of the business. Implied in the description of working capital, is how important it is. A business especially a construction business requires working capital to survive. In accounting terms, working capital is defined as current assets less current liabilities. Working capital management is concerned with short-term aspects of corporate finance activities with the main aim of ensuring that a company has adequate access of funds necessary for day-to-day operating expenses while at the same time making sure that the company’s assets are put to the best productive use. In other words, it is the effective and efficient management of capital in such a manner that a company maximises return on its assets and minimises payments for its liabilities. Not only is working capital a measure of a company’s liquidity, efficiency and overall health, it spells out a host of things such as the company’s payment to suppliers, its revenue collection, its debt management, inventory management, etcetera (Kumar et al, 2014).

The working capital ratio (current assets/current liabilities) is also an indication of efficiency and shows whether a company can meet its short-term obligations. Values below 1 indicate negative working capital and a sign of future distress (not always the case), and values above 2 indicate that a company is not maximising or investing excess assets. Typically, values between 1.2 and 2 are considered favourable (Investopedia, 2015). According to Thomas (2013), ensuring a balance between disbursement and income requires balancing of concerns. A continuous deficit in the working capital of a company could lead to fire brigade sales of assets (restructuring), re-organisation through company voluntary agreements (CVA), bankruptcy and final liquidation of the company. Therefore, management requires finesse in the timing of receipts and disbursements in a business (Sears et al, 2015). Now, as much as a company needs to

81 preserve a good amount of cash at its disposal, it would be unwise for the same to invest substantial amount of its resources on cash and liquid assets. Further more, effective working capital requires maintaining adequate levels of cash, managing short-term investments, managing account receivables and payables, and managing inventory. Getting this wrong could mean the entity going insolvent. On the other hand, getting it right will ultimately ensure the liquidity and survival of the firm.

2.26.1 Positive and Negative Working Capital Requirements

In a normal operating cycle, working capital will never go negative, as assets will continue to increase with every addition of margin when moving goods from account payables to account receivables. Hence, the operating cycle remains positive. According to Sears et al (2015), depending on a company’s business strategy, both positive and negative working capitals have advantages and disadvantages. Thomas (2013) and Sears et al (2015), suggest that a house builder and a contractor would have a positive working capital requirement and a negative working capital requirement respectively. For example a house builder requires a certain amount of stock for marketing purpose and so, would have paid all the costs of building the house in advance prior to any sale. This implies that the house builder has a positive working capital requirement, as he would need to bridge the gap between payments and receipts out of the pocket or result to borrowing (Thomas, 2013). Positive working capital although good, the house builder would need to exercise prudence in its borrowing because when a company is overleveraged and then sales decrease or the market collapses, the company may find itself filing for bankruptcy (Sears et al, 2015). On the other hand, the contractor has a negative working capital requirement because; firstly he does not need to maintain a stock and is usually paid in advance in the form of mobilization advance payment (Palliyaguru et al, 2006) before placing any orders or making payments to suppliers (Thomas, 2013). Secondly, when work is completed, the contractor can invoice the client before later settling suppliers and subcontractors. That is, the contractor generates cash to grow, while the house builder needs additional cash to grow.

Furthermore, negative working capital associated with construction is usually due to high account payables (line of credit and advance payment) and the ‘pay-when-paid’

82 and ‘pay-when-certified’ policy of many contractors – which leads to contractors delaying payment to suppliers and trade creditors (Richardson, 2005). With the use of this strategy, negative working capital increases a company’s cash flow as this means more immediate cash in the bank. Hence, the contractor can use the excess cash to finance other opportunities such as housing and property development. The contractor is safe to do this as long as turnover continues to increase (Engstrom, 2014).

As stated earlier, this business strategy may prove profitable as long as turnover does not fall (Engstrom, 2014). But if turnover falls, (a regular occurrence in the last few years), then the immediate cash availability falls proportionately and the contractor is left with bills to pay with no short-term cash. According to Engstrom, many construction insolvencies happen in this exact fashion. This situation right here, Engstrom states is the “counter curse of negative working capital.” In his words:

“This I recall the managing director of a substantial divisional contractor telling me that “cash comes in like a train and goes out like a rocket”. And when turnover reduces – as we have seen over the last two to three years – there is a corresponding reduction in contractor’s cash/debt balances. This is the counter “curse” of negative working capital, exacerbated in construction because the outflow is much stronger when sales are reducing to a lower level, than when they have stabilised at the new lower level. In other words, the cash position is worse on the way down than it is when you get to the bottom!”

In a situation where a contractor has negative working capital and adopts this strategy of investing excess cash on other ventures to maximise cash flow, the contractor can easily find himself in a “turnover trap” when turnover falls, and is left with a surplus of unfinished project that need cash to progress. According to Engstrom (2014), the contractor is left with “many more payments to be made than receipts to be taken, at the same time … the final settlements for additional work/claims have still to be agreed”. But the contractor has taken the cash and spent it on other investments without

paying his subcontractors and suppliers or even providing the service for the customer. The contractor here, faces some tough choices asserts Engstrom, and can do any or a combination of the following: sell off assets to raise cash; under-price or reduce margins keenly to win new contracts to help with short-term cash flow; squeeze the supply-chain; or bankruptcy.

83 Negative working capital also indicates a high dependency on trade creditors or suppliers. This affects relationships. Now if these delays in payment accumulate to a point where suppliers and subcontractors are not happy and they decide to withdraw their support, the contractor would have to wind up the business. Suppliers and subcontractors will be well in their rights to pathways with a contractor who withholds payment for a long time because in return, that affects their cash flow as well. Many subcontractors and suppliers, unfortunately, have gone out of business because of non- paying main contractor. The Construction Supply Chain Payment Charter came into effect in 2014, hopefully things get better for subcontractors and suppliers from here on end (Department for Business, Innovation and Skill, 2014; HM Government, 2014). The charter states:

“Our ambition for 2025 is that the construction industry’s standard payment terms are 30 days and that retentions are no longer withheld. 30 days/30 days & ZERO retentions”

Other possible circumstances that can result to a contractor having a negative working capital are: abnormal loss of inventory, bad debts, and consistent losses on projects due to under-pricing (suicide bidding) or some unfortunate circumstances (eFM, 2015).

2.26.2 Change in Operating Working Capital

Looking at a company’s balance sheet and calculating its working capital for a given period, tells us very little and would not mean much to any investor or analyst. However, a change in working capital from one period to the next, tells a host of things about how the company is run; it shows how much the company spends on its assets, it shows whether a company has a good collection policy, it show its debt management policy, dependency on supply-chain – whether it pays its suppliers quickly or it delays payment, etcetera. Therefore, in looking at working capital, it is better to look at the individual items that comprise ‘operating assets’ and ‘operating liabilities’ and to see to what degree are they changing relative to each other. What that means is that the focus should be on the assets and liabilities that are critical to the company’s actual business. Those assets and liabilities that are not related to the company’s financing but are rather necessary for the day-to-day running of the business and that are current in nature. Meaning they are only good for usually up to a year or less. For operating assets (incomes), the most common are: account receivables, stock, and prepaid expenses; and

84 for operating liabilities (disbursements), the most common are: account payables or trade creditors, deferred income, and accruals (Thomas, 2013: Sears et al, 2015). So the difference between the disbursements and incomes would result in a negative or a positive (excluding cash and debt) operating working capital, which shows how management manipulates the company’s current assets and current liabilities to fund its on-going operations. This manipulation of assets and liabilities shows the net effect on cash flow, since, effectively “when a company increases its current assets, it is a cash outflow: The company had to shell out money to buy the extra assets. Likewise, when a company increases its current liabilities, it is a cash inflow: The added liabilities, such as short-term debt, provide money” (Morningstar, 2015). Investors and

lenders usually pay attention to a company’s Change in Operating Working Capital to determine its free cash flow whether a company can consistently reproduce high ROI and therefore to lend or not.

A positive Change in Working Capital (excluding cash and debt) indicates that current liabilities are increasing by more than current assets. That is, liabilities are going up or current assets are being sold. It could also mean one or a combination of the following; that the company is increasing its turnover, thereby, increasing deferred income; delaying payment to its suppliers, has little or no stock, may be getting paid up-front, and/or has a good collection policy. A company with a positive change in working capital should enjoy an increase in its cash flow but must be careful not to do this for long periods of time as the company could become overleveraged. In the case of construction companies, it is particularly bad because when turnover decreases, and attempts to raise additional cash through sale of assets or loans prove unsuccessful, then the company becomes insolvent. In addition, a prolonged positive change in working capital that is as a result of delays in paying subcontractors and suppliers could affect future relationships and could generate a bad reputation for the contractor amongst subcontractors and suppliers for non-payment.

On the other hand, if the Change in Working Capital (excluding cash and debt) is negative, it indicates that current assets are increasing by more than current liabilities. This could mean that a company is deleveraging, or it is investing heavily in growth, or that something has gone wrong (Morningstar, 2015). It also indicates one or a

85 combination of the following: turnover is decreasing, too much cash tied in stock, a poor collection policy i.e. it is too lenient with its trade debtors, and probably paying trade creditors too quickly (Thomas, 2013). A company with a negative change in working capital, although deleveraged, may suffer cash flow problems if it does not have a lot of cash or cannot easily convert its stock and receivables to cash. Such a company would need to borrow money in order to survive, thereby increasing its liabilities. Depending on the company’s business model, these changes may or may not affect the operating cycle (eFM, 2015).

The Change in Working Capital is defined as Old Working Capital minus New Working Capital, Or:

(Old Current Assets - Old Current Liabilities) - (New Current Assets - New Current Liabilities)

= (Old Current Assets - New Current Assets) + (New Current Liabilities - Old Current Liabilities).

-When an asset goes up, cash flow goes down because the company is spending money and it serves as cost to the company... and

-When a liability goes up, cash flow goes up, because that frees cash... and vice versa. In other words, if the net change in working capital is positive, FCF increases, and if the net change in working capital is negative, FCF decreases.