Looking for answers to your company’s performance questions? You might want to check your financial ratios. Identifying major trends through ratio analysis can help you translate the information into ways of enhancing your company’s performance.
The key to ratio analysis is knowing which ones are important. In most cases, ratios have useful meaning in and of themselves, but the real story lies in both reviewing and understanding the causes of the ratio trend over time and comparing the ratios to the industry’s best-of-class companies.
Liquidity Ratios
Liquidity measures a company’s ability to maintain adequate cash to meet its financial obligations. Two ratios are commonly used to evaluate liquidity: current and quick.
The current ratio divides current assets by current liabilities. Current assets are those that are reasonably expected to be converted to cash or sold within one year. Current liabilities are expected to be paid within one year.. Before applying the ratio, it’s important to ensure the quality of current assets. If the assets include non-performing receivables, costs in excess of billings on contracts, slow-moving inventory or assets that won’t quickly turn to cash, the current ratio may produce misleading results.
A current ratio of 1.0 indicates that current assets = current liabilities. As the ratio increases, so does a company’s ability to pay its obligations. To comfortably manage cash flow, a current ratio in the range of at least 1.5 to 2.0 should be maintained.
The quick ratio is similar, except it includes only current assets that are cash or can be converted to cash quickly. These assets generally consist of cash, current contract receivables and short-term liquid investments. Since this ratio is based on converting assets to cash quickly, poor billing and collecting practices will minimize its value.
The quality of the assets used in these computations will determine the effectiveness of the information provided. It is possible to have good current and quick ratios and go broke due to the inability to generate sufficient cash to meet obligations.
Leverage Ratios
Leverage ratios measure a company’s vulnerability to business downturns. Generally, the more equity, the lower the risk profile and the increased staying power of the company. The debt-to-equity ratio measures the relationship between capital provided by creditors and capital provided by owners. It is computed by dividing debt—all outstanding liabilities—by equity. The higher the ratio, the more risk assumed by creditors. A lower ratio indicates more financial stability. This ratio varies by classification within the construction industry.
Profitability Ratios
Profitability ratios measure net earnings—usually before taxes—against a base amount. The base amount is generallycomprised of revenues, equity or total assets. These ratios evaluate management’s operating performance and are commonly stated as a percentage.
Return on revenue is computed by dividing net earnings (before taxes) by total revenues. This calculation measures the relationship of net earnings to gross revenues and indicates the margin for error.
Return on equity measures the profit generated on owners’ equity or the net assets, i.e. total assets minus total liabilities. This ratio reports the return on investment to owners. Return on equity divides net earnings by total equity. A high rate of return is desired, but it may indicate a need to retain more equity. Conversely, a low rate of return may indicate a well-capitalized company. The components of this ratio must be analyzed with the result to determine whether earnings or equity is driving the result.
Return on total assets divides net earnings by total assets to measure management’s effectiveness in employing assets.
While other financial ratios can be used, those detailed above offer a comprehensive view of a company’s overall financial health. The following examines how to improve the financial performance driving those ratios.
Selling the Job
The sale of a project determines profitability and cash flow as significantly as execution. Starting a project with proper pricing helps ensure gross margin to cover costs and targeted return on investment. There are two main objectives to the selling process: the company must create value in the minds of its customers to preserve profit margin, and it must understand what the contract will cost to perform. If customers do not value the service offered or consider it a commodity, it will be priced accordingly.
Project Execution
Labor management provides the best opportunity for increasing profits and the biggest risk for contractors. A smooth project turnover process ensures optimum opportunity for the project team to execute the project. Effectively scheduling and planning will lower direct job costs and increase gross margins. Another opportunity to control costs during project execution is using job cost variance analysis.
Change Orders
Contract revenues are usually computed using the percentage of completion method of accounting, which requires the contractor to estimate the ultimate gross profit on each contract.
Many factors make determining final gross product difficult to estimate. Projects are rarely built as designed and job conditions almost always differ from expectations. Because changes have a tremendous financial impact on the outcome of any contractor’s job, firms should have a systematic approach for managing change orders. Written documentation will provide a formal starting point. Job cost records should state separately the costs of each change order. Effectively capturing and selling change orders increases the project’s gross margin the same way increasing the sales price does.
Overhead Cost Control
Contractors that are too thin in overhead are usually rewarded with under-managed projects and a loss of control over project costs. This often results in losses greater than any overhead savings might achieve. Improving profitability by increasing revenue or controlling costs can dramatically improve your company’s financial ratios. There also are opportunities to increase profitability through improved financial or asset management.
Asset Management
Billing and collection practices provide the primary opportunity to manage assets. Accelerating these practices allows contractors’ cash to increase asset turnover in their companies. Other ways to manage assets include reducing investment in property, plant and equipment.
In this economy, every dollar counts. Bids and pricing require contractors to pay attention to every dollar. Efficiency and productivity are at the heart of the lower unit costs that make contractors competitive. Through selling value, margins and profitability can be preserved. These measurements and ideas can help you meet and exceed your company’s financial goals.
The professionals at our office can help you develop strategies to help your business improve its profitability. Call us today.