Tag Archive for 'Gross Profit Risk Factor'

Numbers Tell a Story: Creating Your Story Through the Use of Ratios

By Kenneth J. Hedlund, CPA and Lindy L. Hylton, CPA, MBA

There are many challenges businesses face, especially construction companies in today’s economic environment.  It is important for a company to have a good handle on where they are today and a plan of where they are going tomorrow and beyond.  One way for a company to measure and track their progress is through the use of financial analysis and ratios.  These tools help your company plan, benchmark and monitor progress toward the goals of the company.

In setting goals for your company, you must be objective in using benchmarks and measurements.  You want your goals to be attainable to motivate action, so be realistic in setting goals.  You want to at least meet your goals, but it would be ideal to exceed your expectations.  To get the process started, identify areas of improvement and needed growth within your company and then measure progress of meeting those goals through the use of key ratios.

There are many ratios to use in measuring your company’s financial position and monitoring the progression of goals.  A great place to start is by taking the financial data from your company for the past three to four years and comparing the data over the years.  All numbers tell a story.  What do your numbers tell, and what are they telling your bankers and bonding agents?  Are your revenues increasing? Do you have a cash shortage?  Is your gross margin expected to increase or decrease from prior years?  What has changed over the time period?  What kind of changes would improve the future numbers?

Ratios are powerful in that they are able to tell you the story of your company.  They allow you to link your financial statement numbers to timely and accurate information you can use in monitoring your company’s activity.  There are many ratios to consider, but the following are more contractor-driven and may be most meaningful to you:

Working Capital is the difference between a company’s current assets and current liabilities.  It is generally thought that a higher working capital position indicates a company is better able to pay its short-term obligations within terms.  This ratio also helps evaluate the ability to fund projects.

Debt to Equity is total liabilities over total net worth.  This expresses the relationship between creditors and owners.  It indicates the degree of protection provided by the owners for the creditor.  A lower ratio generally indicates greater long-term financial safety.  Companies with lower ratios usually have greater flexibility to borrow in the future.  Generally, lenders and sureties consider a ratio of 3 or lower acceptable.

Cash to Overbillings is cash divided by billings in excess of cost and estimated earnings.  This ratio is used to identify whether the cash from “front-end billings” has been collected and spent or saved as cash.  Typically, lenders and sureties prefer this ratio be at least 1:1.

Underbillings to Equity is cost and estimated earnings in excess of billings over total net worth.  This ratio indicates the level of unbilled contract volume being financed by the stockholders.  It is usually stated as a percentage.  A ratio of 20% or less is considered acceptable by lenders and sureties.

Backlog Gross Profit is the total project profit less profit earned job-to-date.  This ratio indicates the future estimated gross margin on open contracts.  You want this to be at least the current gross profit margin on completed contracts.  Generally, backlog gross profit should exceed 50% of general and administrative expenses.

Days in Accounts Receivable is net receivables times 365 days over revenue.  This indicates the number of days to collect accounts receivable.  A lower ratio indicates a faster collection period and thus more liquidity.  A higher number of days in accounts receivable ratio may indicate a drain on the company’s cash flow.  Generally, a ratio of 60 days or less is desirable.

Days in Accounts Payable is accounts payable times 365 days over total cost.  This indicates the average number of days it takes to pay trade payables.  The ratio should be compared to the credit terms with vendors.  Generally, a ratio of 45 days or less is considered acceptable.

Gross Profit Risk Factor is the completed contracts gross profit over work-in-process gross profit.  This indicates the amount of gross profit dollars from completed contracts, which are not influenced by the estimating process, in respect to gross profit from contracts-in-process, which are based on the estimating process.  Ratios greater than 1.0 may indicate a poor backlog or a significant decrease in the company’s gross profit.

Equity Risk Factor is equity over work-in-process gross profit.  This indicates the amount of equity that is based on the estimating process and is subject to change.  Amounts greater than 2.0 may indicate a poor backlog of a company that is overcapitalized.

Estimating Risk Factor is the completed contract gross profit percentage over work in process gross profit percentage.  This could indicate that open jobs are not profitable, have lower profit margins or be fewer in number than closed jobs.  An even balance of gross profit between completed contracts and work-in-process is 1.0.  A ratio greater than 1.0 means a larger percentage of profit is taken from closed jobs and could indicate profit gain, a shortage of backlog or decreasing margin on contracts.  A ratio less than 1.0 means larger percentage of profit on open jobs, and could indicate profit fade, increase in backlog or increase in margin on contracts.

After calculating ratios, you can step back and piece your story together from the results.  Ratios raise questions, and with those questions, you can use other related ratios to help piece the story together.  For example, consider the following information for XYZ Company:

Cash $    5,000
Billings in Excess of Costs and Estimated Earnings $100,000
Accounts Receivable $150,000
Accounts Payable $  50,000
Revenue $730,000
Costs $260,715

At first glance, you may think that the overbillings have been spent.  But if you look to see if those overbillings have been collected, you may find the accounts receivable balance is three times the accounts payable balance.  Calculating the following two ratios below help in reading this story:

Days in Accounts Receivable 75 days
Days in Accounts Payable 70 days

The number of days in accounts receivable is 75 days and accounts payable is 70 days.  Now you can conclude that the cash is not spent, and the amounts are still in accounts receivable.  Now further questions can be asked.  For example, is there a problem with the job? Are there customer collection problems? Is there a lot billed but not collected timely.

This is just one example and a few of the many ratios you can utilize in breaking down your company’s story, identifying areas of needed change within your company, setting goals and redirecting your company’s story as the future unfolds.

Summary of key contractor ratios mentioned in this article:

Ratio

Formula

Summary

Working Capital Current Assets –Current Liabilities Higher working capital indicates a better ability to pay creditors and fund projects.
Debt to Equity

Total Liabilities

Total Net Worth

Indicates financial safety.  Lenders and sureties prefer a ratio of 3 or lower.
Cash to Overbillings

Cash

Billings in Excess of Costs and Estimated Earnings

Help identifies if cash from “front-end billings” has been collected and spent or saved.  Lenders and sureties prefer at least 1:1.
Underbillings to Equity

Costs and Estimated Earnings in Excess of Billings

Net Worth

Indicates level of unbilled contract volume financed by stockholders.  Ratio of 20% or less is desirable.
Backlog Gross Profit Total Project Profit –Profit Earned Job to Date Indicates future gross profit on projects in process.  This should at least be the current gross profit on closed jobs.
Days in Accounts Receivable

Net Receivables x 365

Revenue

Indicates number of days to collect receivables.  Ratio of 60 days or less is desirable.
Days in Accounts Payable

Accounts Payable x 365

Total Cost

Indicates number of days to pay trade payables.  Generally, a ratio of 45 days is acceptable.
Gross Profit Risk Factor

Completed Contracts Gross Profit

Work in Process Gross Profit

Indicates gross profit dollars from completed contracts in respect to gross profit dollars from work-in-process.  Ratios greater than 1.0 may indicate a poor backlog or decrease in company gross profit.
Equity Risk Factor

Equity

Work in Process Gross Profit

Indicates amount of equity based on the estimating process.  Amounts greater than 2.0 may indicate a poor backlog of an over-capitalized company.
Estimating Risk Factor

Completed Contract Gross Profit Percentage

Work in Process Gross Profit Percentage

Indicates if open jobs are not profitable, have lower profit margins or fewer in number than closed jobs.  An even balance of gross profit is 1.0.  Ratio of greater than 1.0 means larger percentage of profit is taken from closed jobs.

 

ACP-Somerset Contractor Best Practices. In future ACP publications, Somerset CPAs Construction & A/E Team will continue to contribute articles in the areas of contractor management best practices as well as financial and tax updates.  In addition ACP and Somerset are hosting a series of webinars—The Contractor Success Series. This exclusive industry-specific series provides participants with priceless information with practical application of the subject matter focused on: financial success, operational efficiency and risk management, optimizing employee performance, developing a culture of business development and maximizing customer satisfaction. Success in these key areas will maximize return on investment (ROI). Learn more and register online at www.Somerset-Team.com.

GThis article appeared in the June 2012 issues of the Associated Construction Publications (ACP) magazines national section.