Determining your company’s successful performance or identifying its risks by analyzing complex financial information can be challenging. Financial ratios can provide management with excellent tools and useful indicators of your company’s performance and financial situation.
Financial ratios are classified according to the information they provide. Liquidity ratios indicate a company’s ability to finance growth internally, fund expenses during seasonal lulls, or ride out an economic downturn. Efficiency ratios measure the efficiency of the company in turning over inventory, receivables, or payables. Leverage ratios indicate the long-term solvency of the company. They are usually used by lenders in setting loan covenant guidelines. Profitability ratios measure the success of the company at generating profits. The most common ratios measured by contractors within the classifications above include the following:
- Liquidity and Efficiency Ratios:
Current ratio (current assets ÷ current liabilities): The higher, the more liquid the company is. Generally, a minimum of 1.0 is acceptable.
- Quick ratio (cash and cash equivalents + short term investments + net accounts receivable ÷ current liabilities): The higher, the stronger the company is. Generally, 1.0 is considered a liquid position.
- Days of cash (cash and cash equivalents x 360 ÷ revenues): Generally, seven days is acceptable.
- Days sales in receivables (net accounts receivable x 360 ÷ total revenue): Generally, less than 60 days is acceptable.
- Days sales in accounts payable (total accounts payable excluding retainage x 360 ÷ total costs): Generally, less than 30 days is acceptable.
- Debt to equity (total liabilities ÷ total net worth): Generally, 3:1 for a heavy equipment company and 4:1 for a general contractor is considered acceptable.
- Revenue to equity (revenue ÷ total equity): Generally 15 or less is acceptable.
- Equity to general and administrative (G&A) expenses (total equity ÷ G&A expenses): Generally, 1 or more is acceptable.
- Gross profit margin (gross profit ÷ revenue): The company would have to compare the results of this ratio to the company’s goal for gross profit.
- Net profit margin (adjusted net income before taxes ÷ revenue): The company would have to compare the results of this ratio to the company’s goal for net profit.
- Return on assets (net income before taxes ÷ total assets): The higher, the better. Generally, 10 percent or more is acceptable.
- Return on equity (net income before taxes ÷ total equity): The higher, the better. Generally, 15 percent or more is acceptable.
A more comprehensive approach to measuring your company’s performance is trending your financial ratios over the past five to seven years. In addition to the financial ratios noted above, some additional financial indicators to track over time include:
- Billings in excess of costs to total assets
- Costs and earnings in excess of billings to total assets
- Months in backlog
- Backlog to working capital
- Direct materials to revenue
- Subcontractor expense to revenue
- Direct labor to revenue
Industry benchmarking – comparing the company’s financial performance against industry peers – adds another layer to the usefulness of the ratios and provides important insights into industry issues. Industry peer data can be obtained from a number of sources such as Construction Financial Management Association’s (CFMA’s) Annual Financial Benchmarker and the company’s surety/underwriter.
These techniques used together in analyzing your company’s financial information will aid in efforts to be solvent and profitable. Learn more about financial ratios, benchmarking your company’s performance, or other issues relevant to the construction industry by contacting a member of LaPorte’s Construction Industry Group.