Financial Ratios Drill Down to Measure Performance

By Jim Jordan

With a new year on the doorstep, January is always a good time for contractors – indeed all business owners – to determine how well they're doing compared to past years. Without this information, the future for any business is little more than a roll of the dice.

Jim Jordan is director of construction services for Weaver and Tidwell LLP. With offices in Dallas, Fort Worth and Houston (weaverandtidwell.com).

One of the easiest ways for business owners to assess past performance is by means of financial ratios. Drawing on simple math, ratios allow contractors to see whether they are improving year by year. The process often reveals trends that might otherwise be hidden. Ratios identify and evaluate critical relationships within a company’s financial and operational information. They are more instructive than dollar values reported in financial statements.

There is another benefit to ratios as well: Each year the Construction Financial Management Association issues a survey that reports the ratios of contractors according to geographic location, size and revenue. By reviewing this information, contractors can compare themselves to their colleagues and quickly learn where they are above average and where they need to improve.

Although there are countless ratios that can be used, there essentially are four broad categories of ratios: liquidity, profitability, leverage, and efficiency. Within each of these categories there are several sub-ratios.

Let’s take a look at the categories that are most important for contractors.

Liquidity In a discussion of financial ratios, liquidity refers to the extent to which a company can pay for its obligations and liabilities as well as properly finance future work. Banks, financial institutions and sureties look to liquidity ratios to measure the risk involved in underwriting the contractor.

The three important ratios for determining liquidity are current ratio, days of cash on hand and working capital turnover. Current ratio is the most commonly used measure of short-term solvency. To determine the ratio, divide current assets by current liabilities. In construction, the ratio should be greater than 1.1 (current assets) to 1 (current liabilities).

It should be noted that there is a conservative variation on the current ratio called a “quick ratio.” This ratio looks at current assets, but only those that can be quickly converted into cash to meet short-term liabilities. Many lenders are interested in this ratio because it does not include inventory, which may or may not be easily converted into cash. To determine a quick ratio, you add cash, stocks and bonds held for investment, and accounts receivable, then divide the sum by current liabilities.
 Cash-on-hand and working capital turnover are other ratios that measure liquidity and the firm’s ability to finance its operations.

Profitability A profitability ratio demonstrates the effectiveness of utilizing assets and equity. It measures profits as a percent of the owner’s investment. Investors and business owners often use this ratio to determine management’s overall operating efficiency and the level of return on capital investment. The profitability ratio often is determined by looking at return on assets and the return on equity.

Many industries focus on the gross-profit percentage as a key ratio. However, in the construction industry it’s better to look at net income as a percentage of revenue. Net income as a percent of revenue allows for a better comparison with peers because of differing methods of recording job costs. By using net income in the ratio, the impact of deferring accounting methods in minimized.

Leverage This ratio is a means by which contractors can determine their long-term staying power. That is, their ability to meet all financial obligations over an extended period of time. It most often is derived by looking at debt to equity, revenue to equity, under-billings to equity, and the fixed-asset ratio. The simplest way to determine the leverage ratio is to divide total debt by equity (net worth).

It is important to note that a contractor’s leverage ratio for a single year can be skewed by some kind of anomaly. For example, a contractor may have won a lot of government work over the past 12 months, which created an explosion in new business. As a result, debt increased at a faster rate than equity. In this case, the debt-to-equity ratio will worsen, but can be easily explained. To keep such anomalies from rendering this ratio useless, contractors need to look at their operations over the past three to five years and always be able to accurately interpret the ratio trends.

Efficiency Working capital lies at the heart of the efficiency ratio. This ratio indicates whether a contractor has enough capital to fund his backlog of work. The ratios that most effectively determine an overall efficiency ratio are the backlog-to-working-capital ratio, and the accounts-receivable ratio.

Establishing a rule of thumb for the backlog ratio is difficult. In the construction industry, a contractor must have enough cash on hand to continue taking on new work even though the company may be owed money on projects that are under way or   completed. This can be a bigger problem for contractors that don’t need to keep a lot of cash on hand because their debt level is low.

Another key ratio is the accounts-receivable turnover. This ratio shows the number of times a company’s receivables turn into cash each year. This is most helpful when compared to previous years. For example, if receivables were being collected in 45 days on average during 2006, but 65 days in 2007, there is a problem somewhere. It may mean a close examination of the type of work contracted in 2007 compared to previous years.

Ratios are simple to determine, but some contractors may need assistance. That can be provided by an outside CPA specializing in the construction industry. Again, one of the best places to start is CFMA (cfma.org) and its annual industry survey.