Even sophisticated construction businesses can struggle to interpret their financial statements. In this industry, construction business owners, chief financial officers and controllers need to be on top of compliance, project progress, labor management and so much more.
It’s no surprise that financial data and analysis are sometimes lower on the priority list — particularly when business is plugging along, contracts are being signed and contracts in progress are on schedule.
However, the information within financial statements can shed light on performance levels, highlight opportunities and suggest areas for improvement. This article will cover a few of the ratios you can use to gain actionable insights from your financial information.
What to Expect From Financial Statement Analysis
Your business can make tangible improvements based on its analysis of financial statements.
It takes some investment in training to know what to look for, but the results speak for themselves. By improving financial literacy and reviewing statements with an analytic approach, your business can:
- Provide investors, bonding agents and others with accurate performance metrics
- Identify when and if something may be going wrong systematically within the business
- Identify areas of strength
- Identify areas of weakness
- Benchmark your performance against competitors
- Determine bonding and banking capacities
Key Ratios
Each line item on your financial statement represents an important aspect of your business’s financial performance. However, the true extent of the utility of financial statements becomes clear when you measure the relationship between line items. For example:
- Working capital equals your current assets minus current liabilities. Banks and bonding companies may allow for certain items like related party balance and some prepaid amounts, among others, to be excluded or discounted when calculating working capital.
- Stockholders’ equity equals total assets minus total liabilities. Again, some amounts may be discounted against the equity balance when calculating stockholders’ equity, including related party receivable balances.
- Total backlog is the total contract value on all open contracts, minus the revenue earned to date on all open contracts.
- Backlog gross profit is the total estimated gross profit on open contracts minus gross profit earned to date on open contracts. Industry norms suggest that backlog gross profit should amount to at least 50% of your total general and administrative costs for the year.
- Months in backlog is the total backlog divided by revenue earned for the year and reveals the number of months to complete all open work. This ratio is often used to encourage businesses to seek more opportunities when backlogs will be exhausted in fewer than 12 months.
- Total job borrow is the total overbilling minus total underbilling and results in the net percentage of completion adjustment. Positive total job borrow may suggest overbilling, while negative numbers may suggest poor billing practices or inaccurate forecasting.
- Estimated permanent job borrow is the portion of overbilling in excess of total estimated gross profit and represents the portion of job borrow or overbilling made up of estimated gross profit. Calculating this on a job-by-job basis represents the amount of a contract already billed, which will become equity if the contract is completed at or above the amount of estimated gross profits.
- Underbillings to equity can reveal excess underbilling that might appear to bonding agents as a red flag. Ratios of underbillings to equity should not exceed 20%.
- Underbillings to working may similarly invite further scrutiny by bonding agents when exceeding 25%.
- Cash to overbillings ratio of 100% or more means all overbillings are covered by cash in the bank or in accounts receivable. Anything less than 100% could indicate a serious issue.
- Gains and fades refer to the net change in contract profitability from year to year. They can reveal the overall impact of a contract on the bottom line. If a contract fades, it could suggest a poor profit estimate or unforeseen conditions on the jobsite. If a fade is identified, establish if it is a result of recent events or a bad estimate. Contractors’ financial statements depend on accurate estimates, and a trend of bad or missed estimates can be a cause for concern. Contract fades can also result from pending or unapproved change orders that are not yet reflected in contract value. For this reason, understanding the practices relating to change order recognition is essential. Any material impact of gains and fades on the overall profit margin may require a change in the financial statement’s estimate disclosures.
Final Thoughts
Financial statements aren’t just for outsiders like investors and bonding agents. They can reveal areas for improvement, competitive advantages and systemic issues. If your business isn’t using its financial statements to design and refine its strategy, you may be missing out on opportunities that even basic analysis can reveal.
Most importantly, increasing your financial literacy can be straightforward, simple and relatively quick. None of the ratios outlined in this article require in-depth financial training (although that may help), and the financial data they rely on should already be within reach for virtually all contractors and construction business owners.
Finally, with these ratios, you’ll be able to get a sense for the actionable insights that can be derived from financial statements at a glance. Hopefully, that will prove useful in and of itself and serve as an indicator of the value that more comprehensive analysis can unlock, encouraging your business to make financial analysis a cornerstone of its growth strategy.