Accounts Receivable to Accounts Payable (AR/AP)
The accounts receivable to accounts payable ratio is a measure of liquidity. You calculate this ratio by looking at the balance sheet. It is calculated by:
Be careful to use only trade receivables and trade payables (i.e. receivables from customers and payables to supplies). Do not include any receivables or payables from employees, officers, friends, relatives, etc.
If 50% or more of your sales are COD, then use trade receivables plus cash divided by accounts payable to determine this ratio.
The ratio should be 2 or higher. If it is under 1 then your company is probably in trouble. Sales and receivables are not great enough to cover what is owed to suppliers. If this is the case, then look at pricing very carefully. You are not charging enough to cover daily expenses. You are “robbing Peter to pay Paul.” And, if that continues you will not be able to pay payroll and other weekly expenses.
In this situation you must use the inventory on the trucks and in the shop rather than buying new inventory, increase your closing ratio on replacement sales (if possible) and raise prices immediately.
Debt to Equity
This financial ratio is a measure of capitalization of the company.
The debt to equity ratio looks at how much debt your company has in relationship to the worth of the company. If you have a negative net worth, this means that you have more debt than you have assets to cover the debt. It usually means that the company has not been profitable. You must turn the company around if you want it to survive.
Most contracting companies are undercapitalised meaning that the majority of money that was put into it is a loan investment. You calculate this ratio by looking at the balance sheet. It is calculated:
Total Liabilities Equity
Total liabilities include both short term and long term liabilities. Long term liabilities are debts that the company has incurred that are more than a year in length. These usually include vehicle loans, building loans, and investor loans. Total equity is usually stock invested, paid in capital, and retained earnings.
This ratio should be as low as possible. However, for most contracting companies it is around 2 to 3. It should definitely not be negative!
If the ratio is negative it means that the net worth of the company is negative. If the company is seeking a bank loan, very few bankers will extend loans when a company has a negative net worth unless there are extenuating circumstances and there are assets that the company can pledge. A negative net worth means that the company is probably in trouble because it has been losing money for a long period of time.
To improve the debt to equity ratio (i.e. make it smaller) increase the profits. This means more profitable jobs and more productivity.
Long Term Debt to Equity
The long term debt to equity ratio is also a measure of capitalisation. You calculate this ratio by looking at the balance sheet. It is calculated:
Long Term Liabilities Total Equity
Again, make sure that items that should be listed in long term liabilities are listed there. If there are bank loans and no current portion of these loans is listed, then this ratio will be overstated.
This ratio should be less than one and zero or greater. It should definitely not be negative! (See the explanation for Debt to Equity). There are some contracting companies who have no long term liabilities and that is ok. They pay cash for all of their assets and don’t owe a bank for anything. For these companies, this ratio will be zero.
I have a tendency to put a low importance on the debt to equity ratio unless it is negative. Most HVAC companies are undercapitalized which means that they used more debt than cash to start and grow their companies.
This shows up in these two ratios. If the company is liquid and not losing money I place more emphasis on the liquidity of the company rather than its debt and equity structure. If the current ratio, acid test, Accounts receivable to accounts payable, and long term debt to equity ratio are within industry standards, I discount the debt to equity ratio if it is high. Even if it is high, the company still has the liquidity to pay its bills on time.
Inventory turns measure how efficiently the company uses its inventory. The turns are calculated on annual costs. Calculate this ratio by using both the P & L and the balance sheet. It is calculated:
Annualized Cost of Goods Sold
To annualise the cost of goods sold use the year to date figures on your P & L. For example, if you have total costs of goods sold for a quarter then you multiply this figure by 4 to get the estimated annual cost of goods sold.
There usually is seasonality attached to annualisation; i.e.: in six months you may have earned 75% of the revenues for the year rather than 50%. However, on a monthly basis assuming no seasonality is usually appropriate. Look at the year end figure and compare it to the monthly figure. If they are close, then assuming no seasonality will be acceptable.
Inventory turns should be between 6 and 12 times per year. If it is greater than 24 then the company may be running to the parts house too frequently (and increasing unapplied labor and other expenses, etc.). If it is under 6 then the company is probably keeping too much inventory on hand.
If these figures are out of line then it is also possible that the inventory figure is overstated (i.e. when was the last physical inventory taken?) or the company has parts that are unusable. In either of these cases, the unusable inventory should be written off or a physical inventory be taken to determine the true inventory level.
This financial ratio measures how long an average piece of inventory stays in the shop before it is used. You calculate this ratio from the inventory turn number. It is calculated:
The result should be under 60 days. If you are a new construction company the inventory days can be as low as 15 days without problems. If the inventory days are less than 10 days then you probably are running to the parts houses too much or very good at practicing just in time inventory control.
This figure measures how efficiently the company keeps track of its receivables. The turns are calculated on annualised sales. Calculate this ratio by using both the P & L and the balance sheet. It is calculated:
To annualise sales use the year to date figures. For example, if you have total sales for a quarter then you multiply this figure by 4 to get the estimated annual sales.
This figure should be 6 or greater. Anything less than six means that the company has a receivable problem. You must address this issue and work towards getting receivables current or within 45 to 60 days.
The receivable days measures how efficiently the company collects its receivables. The days are calculated from the receivable turns figure. It is calculated:
This figure should be less than 60 days and preferably lower than 45 days. If it is larger, then see the explanation for receivable turns. If your company does mainly COD work and your receivable days and if the receivable days are greater than 30, then you have a collection problem.
NOTE: When calculating inventory and receivable turns you must factor in the time of the year. It might be that the company is gearing up for its busy season. The best way to calculate these two ratios is by using the year end statements. This gives you the truest picture. However, if you don’t have a year end statement, do them on a monthly basis. The inventory and receivable days should reflect the time of the year to some degree. (i.e. there will be more inventory at the start of a busy season and more receivables at the end of the busy season).
The inventory days should be less than the receivable days. If the number is greater than you may have an inventory problem.
This ratio measures the productivity of your employees. It is calculated by taking total payroll expenses plus payroll taxes and dividing the result by sales.
Compensation consists of direct labour, office salaries, officer salaries, sales people’s salaries, and payroll expenses (Medicare, unemployment, and state taxes). It does not include workers’ compensation, health insurance or meal/uniform expenses.
Your company’s total compensation as a percentage of total sales should not exceed 20% if you perform mainly new construction work. If your company does mainly service and replacement it should be under 35%. If the percentage compensation is too high, find the department where the compensation is high and determine if you can cut payroll or if you need to grow that department’s revenues.
Remember that one month’s financial ratios by themselves are not going to tell you much. However you should be spotting trends. If something looks wrong, do something about it before a minor problem becomes a major crisis. You want to see your current ratio, acid test, and accounts receivable to accounts payable ratio increasing or remaining the same. You want to see your debt to equity ratio and long term debt to equity ratio decreasing or staying the same (but always above zero). Receivable days and inventory days should be stable and receivable days greater than inventory days.
If you are generating accurate, timely financial statements, and the ratios are in line, you know that your company is healthy. If the ratios aren’t in line, then do something about them so that you won’t have financial difficulties!