Properly managing your working capital is necessary to ensure your architecture, engineering, and environmental consulting (AEC) firm is able to cover current obligations, improve operational efficiency, and invest in the future growth of your business.
What It Is
At a high level, working capital is an important financial metric that helps AEC firms assess their short-term financial health. More specifically, it’s how much cash and cash equivalents are available to cover short-term obligations (e.g. salaries, accounts payable, short-term loans, lease payments, etc.).
How to Calculate It
While there are many different ways to calculate working capital, there are simple calculations you can leverage to demonstrate the current financial state of your firm. Let’s take a look at three common formulas you can use.
The basic net working capital formula looks like this:
Working Capital = Current Assets – Current Liabilities
Another way to measure working capital is by expressing it via the Current Ratio.
Current Ratio = Currents Assets / Current Liabilities
Then there is the Acid Test Ratio, which is similar to the Current Ratio, but excludes certain types of current assets.
Acid Test Ratio = (Cash + Cash Equivalents + Short Term Investments + Current Receivables) / Current Liabilities
To compare, while the Current Ratio includes all Current Assets, the Acid Test only includes cash, cash equivalents, short-term marketable securities, and accounts receivable. Meaning it excludes inventory, prepaid expenses, and deferred income tax.
Now that you know how to calculate these simple formulas, let me explain how to analyze the results for each.
If you have a negative working capital value (meaning current liabilities exceed current assets), or the Current Ratio has a result below 1.0, this is usually an indication that your firm may not be able to meet its short-term obligations. So, the higher the ratio, the better positioned your company is to meet those obligations.
However, if the result is too high, this also means your firm is not efficiently managing its short-term finances (more on this in the next section). While the ideal value of these ratios can vary by industry, typically the result for the Current Ratio should be above 1.2 and the Acid Test Ratio result should be above 1.0.
Why It’s Important
Besides working capital being a representation of liquidity, why is this measurement so important for the success of your AEC firm?
Think of a scenario where your firm is already having a difficult time covering its current liabilities – and then, out of nowhere, your firm has an unexpected major project expense or an overrun. How will your firm cover either of these without the necessary cash reserves? Now we’re talking about a recipe for disaster.
To top it off, if your firm is consistently unable to properly manage current obligations, it can lead not only to issues in the short-term, but it can also potentially lead to something far more severe: bankruptcy.
Now, let’s go back to how you don’t want your firm’s working capital ratio results to be too high for a moment: the reason for this is, it may indicate that your surplus cash reserves are not being used to maximize return for your shareholders.
Here’s what I mean: by having too much working capital, it still means your firm isn’t putting its cash to good use. Putting excess cash “to good use” is done by investing those funds in places that will help the company grow. For example, instead of sitting on a large cash reserve, a better option could be to make a large capital purchase that gives your firm the opportunity to expand in the current market, or even a new market.
So, whether it’s too much, or too little, your firm should constantly be finding ways to keep working capital at a healthy level. Here are some questions to consider when evaluating your firm’s working capital:
- Cash: Is your firm investing excess cash reserves for future growth?
- Accounts Receivable: Can your firm reduce Days Sales Outstanding (DSO) by invoicing quicker or improving its collection process?
- Short-Term and Long-Term Debt: Is there an opportunity to improve your firm’s liquidity by replacing short-term debt with long-term debt?
- Trade Payables: Is your firm making the best use of the payment terms agreed with your vendors (e.g. not paying too soon, not paying too late)?
While there are entire books written on the concept of working capital and the different ways it can be analyzed, the calculations in this post provide a quick, simple method for your firm to evaluate its short-term financial health.
When reviewing your company’s current financial state, the best method is to combine these simple liquidity ratios with more in-depth analyses. This gives a more complete picture of your firm’s ability to successfully finance short-term operations and maximize the management of its assets and liabilities.
Curious about where you can find other topics to help you analyze the health of your AEC firm? Check out The Ultimate ERP Glossary for AEC Firms, where you’ll find 150 AEC industry terms spanning the entire project lifecycle: from project pursuit, to project delivery, to accounting, and more. Click the link below to download your free copy and learn other important ways to assess projects and keep your firm on track!