Learn more about this universally accepted safety net and how to calculate how much working capital is needed
The term working capital may sound like an irrelevant high-finance concept to a small practice just looking to pay its bills at the end of the month, but it’s universally accepted that a working capital safety net is essential for a business’s financial health and stability.
With all this being said, how much working capital is recommended for an architecture practice to have in reserve? And how does one calculate how much is needed?
How much working capital does a practice need?
There is also a broad consensus on the amount of working capital a professional services firm should maintain: the general expectation is that a healthy ratio of current assets to current liabilities (the debts a business owes and must pay within 12 months, for instance wages owed to employees or contractors and income and VAT owed) – often referred to as the ‘current ratio’ – should be about one-and-a-half to two. This means the business has £1.50 to £2 in current assets for every £1 of current liabilities.
‘For most architectural practices, their assets will be their cash and their debtors (the amounts due from your clients), and your liabilities are obviously what you owe suppliers and your rent, tax, VAT, payroll liabilities and any payments servicing short-term loans,’ explains Emily Rae, finance partner at Fletcher Priest Architects.
So, working capital is not the same as cash in the bank - it’s broader than that.
It is important to distinguish between current assets for working capital purposes and longer-term assets such as desks, IT hardware, software and furniture that do not form part of a practice’s working capital.
Cash should be the main element of your working capital, Rae says, and some smaller firms may prefer to focus on their cash targets. If project income is predictable and there are no potential shocks on the horizon, then small practices where staff costs are by far the biggest liability may be happy to maintain two or three months of payroll costs as a cash target, while larger practices may want to keep two or three months of all costs including overheads.
Clearly cash flow forecasting is essential. Rae recommends that even if a practice does not prepare formal forecasts, it should be doing a weekly check on cash and money owed.
‘For any small business, the key is to focus on cash and collecting from your debtors, while keeping an eye on the big pressure points, such as quarterly VAT payments, rent and corporation tax and planning ahead for them,’ she says.
Read more about how architects should deal with clients who don’t pay on time
How do you manage working capital?
Managing working capital is inextricably linked to a business’s operating cycle, which revolves around the time taken to convert work in progress and receivables into cash.
Fletcher Priest will always push for monthly payments on its projects, Rae says. If a client wants to pay fees at the end of a work stage, and that stage is going to take longer than a month, they will always seek to build-in instalment payments within the stage.
‘The longer it's taking you to collect your money, the bigger your working capital requirement is going to be. Architects should not be funding their client’s business,’ she continues.
‘Cash flow is all about invoicing on time, managing a practice’s debtors and being really strict with your credit control. Ideally, a practice should be agreeing maximum 30-day payment terms, and chasing clients to make sure they stick to them. Doing all these things will make a huge difference to managing a business’s working capital.’
Conversely, businesses can have too much cash sitting in reserve and not working hard enough. If this is the case Rae recommends that it should be invested, even if it just in a 30-day higher-interest account. The longer the period of time you can put cash away, the better the interest you will receive, she says. Alternatively, a practice may want to use it to invest in the business, to help fund growth.
What is the golden rule when it comes to raising money?
If a small practice is suddenly stepping up the scale of its projects and looking forward to rapid growth, or has an exceptional cost on the horizon (such as setting up a new office) they may want to consider external finance either in the form of an overdraft facility or bank loan to fund the additional working capital that will be required.
The golden rule when raising money, Rae says, is to plan ahead and talk to banks or lenders as early as possible: ‘A practice will need detailed budgets including earnings forecast and estimated costs and cash flows, and demonstrate how it will meet its repayments.’
Thanks to Emily Rae, Partner, Fletcher Priest Architects.
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