HOW DID YOUR YEAR STACK UP?
by Josh Weiss-Partner, Lutz & Company CPA
The end of one year and the beginning of the next is a good time to check on the financial health of your company. It gives the company a break for the busier months, but also is time when banks or bonding companies look for the annual financial statements to help assess the ability of the company to perform in the coming year. Owners and managers can use the financial statements and related information to gain a better understanding what went well, what did not, and how to improve going forward.
A solid understanding of the financial statements and financial health of the company allows the contractor to benchmark their performance against industry averages and trends. Benchmarking against the competition or against the industry in general may provide an opportunity to improve profitability and the overall financial shape of the company. Benchmarking your company against the industry or against the competition is key, but even benchmarking against your own history can be beneficial.
Think about the best or worst years that you have had. Then think of the things that happened in those years to make the year exceptional. Now, how does the current year compare to those. Clearly, several intangible things probably had to have happened. The weather was mild and that extended the season. Or, maybe the schedule of jobs lined up just right and all were unusually profitable. One thing you can go back to are the financial results and see if those help to analyze the year.
There are several places to look for industry statistics and comparisons. CFMA provides and extensive study in their Annual Financial Survey. Other industry or trade specific organizations may also provide studies or surveys. Every company is unique, but there are a few key metrics that all businesses can review to measure performance.
1. Return on Assets (ROA). Some contactors are so busy working in the business; they do not see how their investments of time, effort and money have grown. The ROA will give the contractor an indication of how profitable the company is relative to its assets. In other words, how much profit do the company's assets produce? To determine the ROA, divide the net income by total assets. The higher the ROA, the better, because it shows you are earning more money on fewer assets. Your assets are efficiently working for the company and generating profit.
For example, a contractor that has net income of $1 million and total assets of $5 million, for an ROA of 20%. A competing firm earns the same net income ($1 million), but has total assets of $10 million and an ROA of 10%. The first contractor is getting production that is more efficient from its assets.
2. Return on Equity (ROE). Calculate ROE to understand how much profit is generated by the company with the money invested by the shareholders. To calculate the ROE, divide net income by shareholders’ equity. A company with $10 million of shareholders’ equity that had $1 million of net income has an ROE of 10%.
3. Fixed Asset Ratio. Determine this ratio by dividing the total fixed assets (property, plant and equipment) by total assets. A high result could indicate that disproportionate amounts of the company’s funds are tied up in fixed assets or equipment. This in turn could indicate that the company lacks the liquidity to fund ongoing operations. A lower number, however, could indicate that the company needs to invest in equipment in order to maximize the company’s returns.
4. Debt to Equity Ratio. Measure the ability of your company’s ability to borrow and repay money by dividing the total liabilities by shareholders’ equity. This ratio is a favorite of sureties and banks. It is an indication of the long term strength of the company and shows the ability of the company to withstand a job or two that may not be as profitable as the company had initially planned. A two-to-one ratio is preferable to the lenders and sureties. A higher number without a plan to bring the ratio back down may give the bank or bonding company an indication that the company is overleveraged and may have issues with loan repayments.
5. Working Capital Turnover Ratio. Working capital refers to the current assets over the current liabilities. To calculate working capital, simply subtract current liabilities from current assets. A larger number offers comfort that the company has the ability to satisfy short term obligations with current assets. To calculate the turnover ratio (the revenue being generated by each dollar of working capital available) divide your sales by your working capital. Generally, the higher the working capital turnover, the better because it means that the company is generating significant revenue compared to the money it uses to fund revenues. However, too high of a ratio may indicate that working capital it too thin and that the company is over extended and may have difficulty meeting short term obligations.
6. Debt Service Coverage Ratio. The debt service coverage ratio considers the total cash flow available to meet annual principal and interest obligations on debt. This takes a formula to determine cash flow divided by the debt service obligations. A debt service coverage ratio of less than one indicates a company does not have the ability to cover their debt obligations. A ratio much higher than one is favorable, as a lender would gain comfort that their loans to the company would be repaid without issue.
With a sound and regular review of the overall financial condition, a company can position itself to improve and gain a competitive advantage. There are several ways and time to analyze the financial health of a company, but yearend provides a prime opportunity and benchmarking can help the company truly realize where they stand.