By Ron Coleman
What good is a tool if you don’t know how to use it properly? Your business isn’t any different. Understanding how your business operates, from a financial perspective, is key to running a successful business. In the previous article, we explored the structure of financial statements; now, it’s time to interpret them.
The best approach is to know what exactly you are looking for; it is surprisingly simple. There are only four outcomes you need to measure to stay in control of your finances:
- Liquidity—determines if you can pay your bills on time.
- 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 a 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 s the company.
The targets that are here are the minimum industry standards recommended by financial institutions and bonding companies.
Liquidity ratios
A current ratio is used to determine the number of times current liabilities can be paid by dividing assets by liabilities. A 1.5 to 1.0 current ratio is considered the minimum standard. You need a minimum of 50 per cent more in current assets than in current liabilities. With a ratio less than 1.5 to 1.0, the contractor may have difficulty meeting current obligations.
A contractor with a current ratio greater than the minimum standard shows good financial strength. When the current ratio exceeds 2.5 to 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.
The acid test ratio (or quick ratio) measures the ability of a business over its current liabilities by using its cash and receivables without the necessity of converting inventory or other assets to cash. To do this, divide the sum of cash and accounts receivable by current liabilities.
The target is a minimum of 1.0 to 1.0. Under this and you are unlikely to meet your current obligations. It should be noted that companies with lower levels of inventory are easier to sell.
Leverage ratios
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 comfortable with a higher level of debt if they have a good history with your company.
Activity ratios
The only activity ratio I will cover is working capital turnover. The age of receivables and payables is misleading due to the peaks and valleys of sales activity; so, use your ledger’s aged analysis to monitor the activity correctly.
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 holdback. Service and retrofit companies with little or no holdbacks require less working capital than commercial and industrial companies doing major projects and 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.
The level of sales you need to break even depends on two factors: your gross profit percentage and the value of your overhead. This is the only profitability ratio that is constant. Aim for a minimum five per cent pre-tax profit on sales. The tprofit, some averaging over 20 per cent.op 25 per cent of contractors consistently earn more than 10 per cent pre-tax profit, some average over 20 per cent.
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 per cent annual rate of return, every year.
There are two approaches to comparative analysis: trend analysis and benchmark analysis.
Trend analysis is comparing your 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.