Accurate and timely financial statements let you do far more than simply track revenues and profits. Prudent executives use them to calculate certain key financial indicators, which create a dashboard of a construction company’s health and performance. While every financial manager has his or her favorites, here are a few of the most widely used metrics:
• Gross Profit and Net Profit. Gross profit (revenue minus direct cost of work) is often used to track individual projects, but it also is helpful in evaluating the company’s job performance in general. Net profit (gross profit minus indirect costs or overhead) provides insight into the performance of the company overall. Both figures can be expressed as an absolute number and as a percentage of revenue.
• Return on Equity. Return on equity is calculated by dividing net profit before taxes by the owners’ equity in the company. This provides a consistent formula for comparing year-to-year performance.
• Return on Assets. This is usually stated as a percentage (for instance, a 5 percent return on assets) to illustrate how effectively your company is using its assets. It is determined by dividing net pretax earnings by total assets.
• Current Ratio. One of the most widely used of all metrics, the current ratio is calculated by dividing current assets by current liabilities to indicate your company’s ability to meet its short-term obligations. A minimum ratio of 1.0 is desirable.
• Overbillings/Underbillings. Overbilling occurs when the billings on a job outpace the costs and earnings under the percentage-of-completion method. Underbilling occurs when billings on a job are not keeping pace with the costs. Ideally, every project would remain prudently overbilled until it reaches completion, but at a minimum, total overbillings should exceed underbillings—a sign that you are managing cash well and working on the project owners’ capital instead of your own.
• Days in Accounts Receivable and Days in Accounts Payable. In addition to monitoring these two individual measures of liquidity, be sure to compare them side by side to be alerted to possible cash flow problems in the near future.
• Debt to Equity Ratio. Another of the most fundamental financial ratios, this measures how highly leveraged your company is by dividing total liabilities by total net worth. A higher ratio creates additional risk. A ratio of 3.0 or lower is usually preferred.
• Months in Backlog. This measures the number of months it is likely to take to complete all contracted work. It is calculated by dividing total backlog by average monthly revenue. A decrease in backlog is an obvious cause for concern. Comparing backlog to other figures—such as fixed overhead, working capital, and owners’ equity—can provide early indications of potential cash flow or leverage concerns.
Remember that financial ratios should not be viewed in isolation. Compare them to industry benchmarks and monitor them regularly—monthly, in many cases—to spot trends and changes.