LGT's Profit Sense

Financial statements are an essential part of understanding the operating results for every contractor. Between the balance sheet, income statement, and statement of cash flows, financial statements can provide a large amount of data, but that data is only a snapshot of the results for a specified period (typically a month or year). How can you leverage this data to provide you with some key financial ratios or key performance indicators (KPIs)?

Decision-makers should analyze and monitor performance on a contract-by-contract basis. By examining the financial ratios and KPIs discussed below and conducting a regular comparison to industry standards and benchmarks, you will be able to monitor performance. Regular evaluation can help identify areas of opportunity or improvement or influence important business decisions.

Backlog

Backlog is essentially your pipeline. Your backlog indicates the amount of future revenue that you will be able to generate from the contracts you currently have in place. When looking at this backlog-specific ratios, you might break them down into more precise detail and look at the following:

• The number of months you have in backlog (current backlog / annual revenue). A good figure to try and maintain here would be anything above 6 months. This indicates that you have enough remaining revenue to replace approximately half of your annual revenue. However, if this ratio gets too high, it could show that you are overextended.
• Backlog to working capital (backlog / (current assets – current liabilities). This measure essentially takes into account how productive your backlog is in generating a return and meeting your current obligations. For this ratio, you want to have a ratio of at least 1:1.
• Backlog gross profit (backlog contract revenues – backlog contract costs). This measure is useful to look at to verify that the remaining contract revenues to be recognized are more than the estimated costs to complete. Ideally, the number here would be large enough to cover any fixed general and administrative expenses such as payroll, rent, insurance, etc.

Liquidity Ratios

Liquidity ratios indicate your company’s ability to pay off short-term debt using your current assets if all of your short term liabilities became immediately due. For each of these ratios, generally, a ratio of 1:1 is considered good. However, if the ratio is too large (current assets greater than your current liabilities), it might indicate that you might be missing opportunities to utilize your assets better to generate greater returns. If this number gets too large, you may consider investing some of your short-term assets (cash) in a long-term asset (such as a CDs, mutual funds, investment accounts, etc.) to generate a greater return than a savings account or money market account generates.   

• Current ratio (“Working Capital”) – Current Assets / Current Liabilities. This ratio includes all current assets and current liabilities in the numerator and denominator. A good benchmarking threshold for this is 1.6:1.
• Quick ratio (“Acid test Ratio”) – (Cash + Accounts Receivable) / Current Liabilities. This ratio is very similar to the above calculation, however inventory and underbillings are removed from current assets in the calculation of the numerator because, often, for a construction company, both inventory and underbillings take much longer to liquidate, and therefore might inflate your ratio. On the current liabilities side, you should also remove overbillings from the calculation. A good benchmarking threshold for this ratio is 1.4:1.

Efficiency Ratios

These ratios really focus on how well you utilize your assets and liabilities.

• Days Revenue in Accounts Receivable – (Accounts Receivable / Annualized Revenue) x 365. This ratio shows you how long it is taking you to collect on your billings. This will vary on a contract-to-contract basis based on what the terms of the contract are; however, a good threshold to have here is approximately 45 days, or 10-15 days over your standard collection terms.
• Days Expenses in Accounts Payable – (Accounts Payable / Annualized Construction Costs) x 365. This ratio shows you how long it is taking you to pay your job-related expenses. This will vary on vendor-to-vendor relationship based on your payment terms. Since cash is king in the construction industry, you would ideally want this number to be greater than your Days Revenue in Accounts Receivable amount to be. This is so that you are not paying for your contract-related costs prior to you receiving payment for your billings.

These ratios indicate how well your company is doing at generating profit utilizing its assets, equity, or just your general ability to turn revenue into profit.

• Gross Profit – (Gross Profit / Contract Revenues). This is one of the most common ratios, and the higher the number here, the better. Ideally, you would look at this both in total as well as on a contract-to-contract basis. This should be analyzed on at least a monthly basis to monitor contract fade and help identify issues or opportunities for potential change orders earlier rather than later.
• Return on Assets – (Net Income / Total Assets). This ratio is an indicator of how profitable a company is in relation to its total assets. This measure gives you an idea of how active your company is in converting the money that is invested in the company into net income. The higher this ratio, the better. A good benchmarking threshold for this is somewhere around 10%.
• Return on Equity – (Net Income / Total Equity). Similar to return on assets, this ratio is also a measure of how effectively management is using the company’s assets to generate profit. However, since equity is equal to total assets minus total liabilities, this represents the return on net assets, not total assets, as reflected in the Return on Assets ratio above. Similar to Return on Assets, the higher this ratio, the better. Since this number is utilizing net assets instead of total assets, this ratio should ideally be much higher than your company’s Return on Assets. A good benchmarking threshold for this is around 27%.

Benchmarking and financial ratio analysis is an important part of understanding your business and can provide useful insight to explore potential opportunities or identify troubling trends and get them corrected quickly. Financial statements provide you with useful information such as your cash balances, gross profit, net income, and cash flows from operations. However, these figures are just point-in-time balances and should be further leveraged to provide you with additional insight. Utilizing financial ratios will help you gain a further understanding of your company. However, just performing this analysis above is not sufficient. You should take a look at the results from this analysis and compare internally month-to-month, year-to-year, or perform benchmarking against your peer group.

Having problems making your financial statements work for you? Contact us and get advice from the professionals.