By Marc Newman, Associate Managing Partner, Anchin, Block & Anchin
Just as a wise patient undergoes regular medical checkups, a construction firm should have regular financial checkups.
Why? Banks and sureties are already paying attention to your company’s financial vital signs, so it makes sense for you to track them as well.
Not only will doing regular checkups help you find and address problems early enough it will also help you maintain your bonding capacity and stay in compliance with loan covenants.
Taking your blood pressure alone tells you little about your overall health, just as no single financial indicator tells the entirety of your construction company’s well-being.
There are numerous ratios and metrics you can use to measure a company’s performance, but it’s important to select a manageable number of indicators that make sense for the needs of your specific company.
A good source of such benchmarking information can be found through the Construction Financial Management Association (CFMA), in addition to other national, regional and local industry groups.
CFMA’s Construction Industry Annual Financial Survey collects data on 20 key financial ratios, providing overall and best-in-class averages for the construction industry as well as for specific regions and industry sectors. These ratios are divided into four categories: profitability, liquidity, leverage and efficiency.
The closer the benchmark data relates to your type, size and location, the more meaningful the data will be.
It’s important to measure your company’s performance in all four areas. Although profitability is every company’s ultimate goal, liquidity is critical, especially in today’s economic environment.
There are countless examples of construction firms that were highly profitable on paper but failed because of inadequate cash flow. Leverage and efficiency also are important concerns because even if your company seems to be thriving now, too much debt or inefficient use of capital and/or assets can signal trouble down the road.
Here are several examples of key financial ratios for construction firms:
Return on equity (profitability). As a general rule, the higher this ratio, (net earnings/total net worth) the better. However, in some cases, a high ratio may indicate that the company is undercapitalized or has too much debt.
Current ratio (liquidity). One of the most popular ratios for contractors, the current ratio (current assets/current liabilities), measures a contractor’s ability to satisfy his or her short-term liabilities with cash and other relatively liquid assets.
Working capital turnover (liquidity). This ratio (revenue/working capital) indicates the amount of revenue supported by each dollar of net working capital used. A higher ratio may signal a need for additional working capital to support future growth.
Debt-to-equity (leverage). This (total debt/net worth) ratio measures the degree of leverage you use. A higher ratio allows you to earn more on your invested equity, but also exposes you to greater risk.
Months in backlog (efficiency). This [backlog/(revenue divided by 12)] ratio shows the number of months it will take to complete all signed or committed work. A lower ratio may mean the company needs new contracts to maintain constant revenue in the future.
Monitoring these and other financial ratios allows you to compare your company’s performance to that of other construction firms in your industry, sector, and region. By watching for changes within your financial ratios over time, you can spot negative trends and identify opportunities for improvement.
Financial ratios are really just a subset of key performance indicators (KPIs). KPIs also include other financial measures, such as unapproved change orders, underbilling, profit fade and overhead creep. Nonfinancial measures include employee morale, schedule variances and customer satisfaction.
Work-in-process (WIP) reports are particularly valuable. Not only do they reveal potential problems, but they also help you identify strategies for dealing with these issues. Suppose, for example, that an analysis of your WIP reports shows a pattern of gross profits that shrink over time, (“profit fade”), or that gross profits on current jobs are consistently lower than on completed jobs. A WIP will show you that there are several possible reasons for this, including poor estimating and/or ineffective project management.
Underbilling is another trend that may indicate management deficiencies. If billings aren’t keeping pace with a job’s progress, it may be a sign of cost overruns, lax management and/or sluggish billing practices. Learning about profit fade, underbilling and other problems early on allows you to address underlying causes before any irreparable harm can be done.
All construction companies should have plans for collecting key financial and non-financial data, monitoring financial ratios and other KPIs, and deciding how to use those indicators to improve their businesses.
By monitoring ratios and other key performance indicators, you can detect early warning signs of financial health problems before they do permanent damage.
Your CPA can help you put together a set of individualized metrics based on the nature of your business and your company’s particular circumstances.