By / Ron Coleman
Introduction
What good is a tool if you don’t know how to use it properly? What good is a set of financial statements if you don’t know how to interpret them? In the previous article, we explored the structure of your financial statements. Now it’s time to interpret your financial statements.
Balance Sheet and Income Statement
The best approach is to know what exactly you are looking for and that is surprisingly simple. There are only four outcomes you need to measure to stay in control.
- Liquidity
Determines if you can pay your bills in a timely manner. - Leverage/solvency
Determines your level of debt and how healthy it is. - Activity
Shows how actively the company is managing its resources. - Profitability
We are in business to make profit.
Liquidity, activity, and leverage ratios are constant for differing types of contractors. An exception being sheet metal contractors who have substantial capital (fixed) assets.
Profitability ratios, except for net operating profit, vary from one trade to another, the type of work done, and the size of the company.
The targets that are here are the minimum industry standards recommend by financial institutions and bonding companies.
Liquidity Ratios
Current ratio (target is >1.5:1.0)
| Formula | Current Assets Current Liabilities | = | Current Ratio |
The current ratio is used to determine the number of times current liabilities can be paid by current assets. Simply divide current assets by current liabilities.
A 1.5:1.0 current ratio is considered the minimum standard. You need a minimum of 50% more in current assets than in current liabilities. With less than 1.5:1.0, the contractor may have difficulty meeting current obligations. A contractor with a current ratio greater than 1.5:1.0 shows good financial strength. When the current ratio exceeds 2.5:1.0, the company may be overcapitalized. In such cases, the excess (redundant) current assets should be invested elsewhere.
The current ratio does not take into consideration the liquidity of the components of current assets. A contractor whose current assets consist mainly of cash and receivables would be more liquid than a contractor whose current assets include a significant level of inventory. The acid test ratio is used to fine tune liquidity.
Acid test ratio (target is > 1.0:1.0)
| Formula | Cash + Accounts Receivable / Current Liabilities | = | Acid Test Ratio |
The acid test ratio (or quick ratio) measures the ability of a business to cover its current liabilities by using its cash and receivables without the necessity of converting inventory or other current assets to cash. Divide the sum of cash and accounts receivable by current liabilities.
The target is a minimum of 1.0:1.0. Under 1.0:1.0 and you are unlikely able to meet your current obligations. (Companies with lower levels of inventory are easier to sell).
Leverage Ratios
Debt to equity or total liabilities to net worth ratio (target < 2.0:1.0)
| Formula | Total Liabilities / Net Worth | = | Debt to Equity Ratio |
It is essential to relate your level of debt to your equity. Can you borrow more money, or do you have too much debt? The total liabilities to net worth ratio is commonly referred to as the debt-to-equity ratio. Divide total liabilities by net worth. The maximum acceptable debt to equity ratio for contractors is 2.0:1.0. In other words, creditors should not have more than twice as much invested in the company as the shareholders. Some financial institutions will be okay with a higher level of debt if they have had a good history with your company.
Activity Ratios
The only Activity Ratio I will cover is Working Capital Turnover. Age of receivables and payables are misleading due to the peaks and valleys of sales activity. Use your ledger’s aged analysis to monitor the activity correctly.
Working capital turnover (target is eight to 12 times per year)
| Formula | Sales / Working Capital | = | Working Capital Turnover |
Working capital is the excess of current assets over current liabilities, or the “net current assets”. The target turnover rate for contractors is eight to 12 times per year. A major impact on the usage of your working capital is the level and rate of turn of your holdbacks. Service and retrofit companies with little or no holdbacks require less working capital than commercial and industrial companies doing major projects, and therefore, would be comfortable with a higher turnover rate.
Profitability Ratios
There are a variety of ratios that you will get from your profit and loss statements. We will focus on the key ones.
Break-even sales
The level of sales you need to break-even depends on two factors. Your gross profit percent and the value of your overhead.
Divide overhead by the percentage of gross profit, multiply by 100.
| Formula | Overhead $ / Gross Profit % | x | 100 | = | Break Even Sales |
Net profit to sales (target is > 5%)
| Formula | ( | Net Profit / Sales | ) | x | 100 | = | Net Profit to Sales |
This is the only profitability ratio that is constant. Aim for a minimum 5% pre-tax profit on sales. The top 25% of contractors consistently earn more than 10% pre-tax profit, some averaging over 20%.
Return on investment (target is >20%)
| Formula | ( | Net Profit / Equity | ) | x | 100 | = | Return on Investment |
Return on investment is the bottom line. Your business is worth a specific cash value. If you invested that money somewhere else, what return would it bring you? Construction companies are relatively high risk and therefore should generate a high return on investment. Our recommendation is at least a 20% annual rate of return every year.
Comparative Analysis
There are two approaches to comparative analysis—trend analysis and benchmark analysis.
Trend analysis is comparing your own results in this period to previous periods. It identifies whether or not the business is improving, where the improvements are, and where dangers might be lurking.
Benchmark analysis is where you compare your numbers and ratios to industry standards. These are the targets we have shown in this article.
This article covers the key financial ratios. If you are out of line on any of these, you should discuss it with your accountants.
Calculate your ratios and I will be happy to review them for you at no charge. I can be reached at ronald@ronaldcoleman.ca ▪
