Using this commonly overlooked forecasting tool can help you understand your company’s financial preparedness.
By / Ronald Eager
Not much about the last two years has been predictable. The uncertainty caused by deteriorating backlogs, ultra-competitive bidding fields, rising costs, and supply chain issues has plagued contractors and made it difficult to set realistic goals and develop plans to reach them.
However, one thing that remains certain is the power of data to understand business performance and plan confidently for the future. From cash flow projections to key performance indicators (KPIs), analyzing the numbers coming out of your construction company is essential to your success in this economic environment.
An effective but commonly overlooked financial analysis tool is the use of financial ratios. Calculating ratios from your financial statement data and comparing them to industry averages and past performance can help you gauge your company’s condition in many key areas and raise red flags for where new financial strategies may be needed in an ever-changing competitive marketplace.
Liquidity
Liquidity ratios measure a company’s ability to repay their short- and long-term financial obligations. Examples include:
Current ratio = Current assets divided by current liabilities. A current ratio of 1.0 or higher indicates that current assets are equal or more than current liabilities.
Quick ratio = Cash, cash equivalents, short-term investments, and receivables (net) divided by current liabilities. This ratio assesses the extent to which more liquid assets can satisfy current liabilities. A ratio of 1.0 is generally considered a liquid position.
Days of cash = Cash and cash equivalents multiplied by 360 and then divided by Revenue. Use this ratio to determine how many days of revenue your cash-on-hand could cover. Generally, seven days or more is considered adequate.
Profitability
Profitability ratios measure your company’s ability to generate income based on factors such as revenue, assets, operating costs, and equity. The return on assets ratio, for example, is calculated by dividing net earnings by total assets, which will indicate how much profit is generated by total assets employed. The higher the ratio, the more effectively you are employing company assets.
Return on equity is another profitability ratio and is calculated by dividing net earnings by total net worth. Typically stated as a percentage, this ratio indicates the profit generated by the net assets employed and reflects the stockholders’ return on investment. A high ratio can mean that the company is either very profitable or undercapitalized.
Leverage
Leverage ratios are used to evaluate your company’s debt levels compared to other financial aspects of the business. Companies with higher debt levels will have a tougher time in down markets. Common examples include:
Debt to equity ratio = Total liabilities divided by total net worth. Generally, a ratio of 3 or lower is considered acceptable.
Revenue to equity ratio = Revenue divided by total net worth. This ratio will show you how much revenue is being supported by equity. Generally, a ratio of 15 or less is considered acceptable.
Underbillings to equity ratio = The total of unbilled work and cost in excess, divided by total net worth. This calculation indicates the level of unbilled contract volume being financed by stakeholders. A ratio of 30% or less is generally considered acceptable.
Efficiency
Efficiency ratios assess how well your company is utilizing its assets and resources. For example, the Backlog to Working Capital ratio indicates the relationship between signed or committed work and working capital. It is calculated by dividing backlog by the difference between current assets and current liabilities (Backlog/Current assets minus current liabilities). A higher ratio may indicate a need for an increase in permanent working capital.
These are just a few of the financial ratios that can help you determine and improve your construction company’s position. And while your surety and banks similarly compare your results to industry averages, financial ratios are equally useful for your company to benchmark your business and evaluate its competitiveness. The full value of this tool lies in comparing your company’s own individual ratios over time. A change in a ratio over a two-year period would indicate your business is getting farther or closer to its financial goals. Tracking these ratios is equally important in good times as in down times.
Your company’s financial statement is more than an annual compliance obligation. It is a wealth of valuable information that can be used to chart a course for a confident future. For more information on how to calculate and analyze financial ratios, email Ronald Eager at reagar@grassicpas.com. ■
Reprinted with permission from May/June SMACNews | smacna.org
