Managing working capital in a low margin environment

The collapse of Carillion brought additional focus on the industry’s tight margins and long payment terms. As such, reducing risk in the construction supply chain has been a growing area of concern for many in the industry. But as these issues can be so embedded, changing payment practices and behaviours may be easier said than done.

Given the combination of tight margins and lengthening payment terms, how can businesses manage working capital while continuing to operate and invest in the future?

Get your processes in order

Any business, irrespective of its position in the supply chain, should manage working capital closely, and at all levels. Working capital is the amount of money tied up in the day-to-day costs of doing business, and is concerned with a business’s efficiency as well as its liquidity.

Businesses that manage it well, taking time to understand their cash flow and future requirements, can therefore take the right steps to keep these sources of funds as accessible as possible.

Having timely and regular management information is critical and, to be effective, working capital processes must be agreed and understood throughout the business, not just within the finance teams, given its cross-functional nature.

Steps to take ahead of contract agreements

Before any new project contract is agreed, businesses should evaluate the impact it will have – not just in terms of long-term profit, but for shorter-term cash flow too. All teams need to understand this impact, and how their company’s payment terms and processes affect it, before agreeing to work.

Producing a cash flow forecast ahead of any project is a good start. This allows you to lay out when you expect to be paid and how long you are prepared to wait before receiving any cash. As projects can often evolve, keeping this up to date can help assess the impact of any changes in scope.

Businesses should also set targets for the amount of work-in-progress they are prepared to carry.

Setting processes at the outset

Once work starts, both financial and operational teams need to ensure invoices are issued and paid on time.

To make sure they are issued on time, invoicing milestones should be clear in the contract, they should include what information is needed and when, and they should be understood by all teams.

For them to paid on time, businesses need to understand their customers’ finance systems. It sounds simple, but both finance and project teams need to know whether a customer needs information in a specific way and by a certain day if they are to work together to meet those requirements.

Standardising the information that is required to support the invoice approval process will also help make the process more efficient.

Ironing these issues out at contract-signing stage will also help finance teams to identify when alternative finance options may be required to cover the gap between issuing an invoice and being paid.

Keeping the business informed

Construction projects can change after work has begun even more than in other sectors, and firms need to be equipped to respond.

Managing work variations so they are agreed, including the financial implications, prior to work commencing can prevent payment delays. Invoicing variations separately from the originally planned work can also often prevent unnecessary delays in approvals.

Project teams should discuss financials, including overdue invoices and work-in-progress, with the customer regularly to manage payment delays.

Having agreed the profile of work, invoicing milestones and payment terms in advance, it should be in all parties’ interest to resolve issues and ensure the project can be managed according to plan.

Most large construction firms now have dedicated procurement teams to negotiate deals with their suppliers, but the benefit of their work can be undone where project colleagues have the freedom to procure their own materials. Missing out on discounts agreed by their procurement department will adversely affect project margins and profitability.

How to release cash elsewhere in the business

The collapse of Carillion has really brought home the impact of late payments. As a result, we are now seeing more businesses act against late payers, with some even taking strategic decisions to stop working them entirely.

But there are other steps companies can take to manage working capital and release funds that can be invested back into the company, or held in cash to help deal with any surprises.

Your advisers can help you analyse the cash cycles of your business, benchmark them against your peers and identify opportunities to improve.

This might involve reviewing the level of working capital a firm has tied up in trade debtors, or using financial products such as supply chain finance to manage risk within the supplier base, or invoice factoring to access some of that cash more quickly.

Failure to manage working capital can cause even large firms to become insolvent. Effective management, by contrast, can free up cash flow – the lifeblood of any business – and equip them for whatever the future holds.