We need to build on working capital successes

With confidence low and flat, and headlines dominated by the fallout from major insolvencies and the question marks posed by the UK’s impending departure from the EU, it’s easy to be downbeat about the outlook for construction.

If you look under the bonnet of the industry’s finances, however, you’ll find the past five years have actually been quite positive for construction. According to the Office for National Statistics (ONS), output has risen by 25 per cent, while our latest Working Capital Index recently revealed contractors have shortened their working capital cycles by an average of four days since 2013.

Put simply, a working capital cycle is the length of time it takes a business to convert what it produces into cash from sales. The shorter that period, the better. Generally speaking, rising sales on credit and inventory increase the cycle, while slower payment times to suppliers reduce the cycle.

Construction firms that have shortened this cycle in the past five years will be more financially flexible. They can generate liquidity quickly, making them better placed to sustain unforeseen shocks, or respond to growth opportunities at short notice - an essential quality for navigating the peaks and troughs of activity the sector is used to.

Larger contractors and engineering firms have set the pace on this front, reducing their working capital cycles by over 30 days, from 105 to 73. Smaller firms have also reduced their working capital cycles, but by much less – from 43 to 41 days.

These are welcome gains, but there is still room for improvement. Given that the construction sector’s supply chain model is vertical, if the industry is going to markedly improve its working capital position further, the most impactful measures will come from the top of the pile.

Payment practices in focus

Lots of factors affect a company’s working capital cycle, but payment practices are pivotal. If money comes into a business quicker than it leaves, it’s a great recipe for shortening the cycle.

Unlike other sectors, slow and late payments affect large construction and engineering firms more than smaller ones, with the biggest contractors waiting an average of 66 days to be paid, compared with 63 days for smaller businesses. To combat this and optimise cash flow, large construction businesses have slowed the average time it takes them to pay suppliers to 62 days.

By contrast, large businesses in other industries across the UK get paid on average in 38 days and pay out after 57.

Payment practices are usually business and industry specific, but these figures tell us some of construction’s biggest players may not necessarily be benefiting from paying later, but instead trying to mitigate the working capital impact of late payments they themselves are owed.

The problem is this tactic can increase financial leverage for the large contractors, while transferring cash flow pressure downwards to smaller contractors, increasing risk for the entire the industry.

Best practice working capital management

Change is afoot. New rules requiring large firms to publicly report their payment practices are already highlighting the range of payment terms and times used by the major contractors. The mandatory use of project bank accounts for public sector works will also likely impact on the working capital of these large contractors.

The sector’s largest firms need to proactively tackle this pressure and lead by example. Payment timing is a combination of culture, strategic direction and process efficiency. The uncertainty caused by the UK’s decision to leave the EU makes any strategic re-evaluation of working capital more complicated. But it doesn’t mean firms should wait and see.

Standardised contractual terms, aligned across the entire industry, are going to become increasingly important. But such a significant shift in the payments landscape will need to come from above. If large contractors start the process and demonstrate best practice by providing contracts with clear terms and invoicing deadlines and managing the cashflow of their current projects better, it will hopefully drive needed strategic and cultural changes at every level of the supply chain.

Project bank accounts will take some time to bed down, but eventually they’ll also create more opportunities for the automation of financial processes and payment flows and improve transparency.

Ultimately, if construction’s biggest players embrace the move towards transparency, change their payment culture and use the greater financial flexibility they create through efficiency to strengthen their suppliers, the positive impact would be felt at every level of the industry.