I look at contractors’ financial statements almost every day. I can tell almost immediately whether the information in those statements is accurate and whether it is worth my time to analyse them. If the information is wrong, then I would be wasting my time analysing and making decisions on wrong things. The old adage is true, garbage in equals garbage out. You can’t count on garbage…except to throw it away. And, that is exactly what you should do with financial statements which are not accurate.
Your financial statements tell you how you are doing each month. They are your scorecard. They tell you whether your company is healthy or needs some work to get healthy. So, where do you look to ensure they are accurate? First, look at inventory. If it is the same dollar amount each month, it is an even number (i.e. $1,000 or $1,500), or there is nothing in inventory, I know your financial statements are wrong. This industry has inventory and it changes every day. Therefore your statements should change every month.
Then look at 10 ratios which tell the story of your company. As I explain the ratios, I’ll describe where to look to make sure the information in each ratio is accurate so you can take action on each one. It is important to compute these financial ratios on a monthly basis because the trends are as important as the specific monthly figures. You can spot trends and help your company avert a potential crisis by examining these ratios on a month to month basis.
The ratios are derived from your balance sheet and profit and loss (P&L) statements. The P & L tells you how you are doing from a profit perspective each month, year to date, and potentially year to year. Your balance sheet is a snapshot of the health of your company. It tells you whether you have enough cash to pay your bills, if you are running out of cash, whether your inventory is getting out of control, or whether you debt level is too high. While your P&L tells you whether your day to day jobs are providing profit, your balance sheet takes a longer view and lets you know whether you have enough cash to operate or whether you are heading for financial problems that you might not see on a day to day basis.
The ten ratios that follow are the ratios that are the most critical to determining how your business is doing. These may not be the ratios that your banker uses when determining whether to approve your loan application. In fact, most won’t know what percentage compensation means. Imagine being able to explain something to your banker! However, if these ratios are within normal ranges, then the ratios that the banker uses will be in normal ranges too.
The current ratio is a measure of liquidity, i.e. how easily can the company pay its bills? You calculate this ratio by using figures from the balance sheet. The ratio is:
For safety, this ratio should be 1.8 or greater. The higher the ratio the better.
Current assets are assets that are cash or can be turned into cash within a year. These usually include cash, accounts receivable and inventory. Current liabilities are debts that the company must pay within a year. Most current liabilities include accounts payable, lines of credit, taxes payable, service agreement deferred income, and the current portion of long term debt (i.e. one year’s principal of a three year truck loan).
When examining the balance sheet make sure the assets and liabilities appear in the proper locations. Only include current assets that are really current assets. Make sure that property, buildings, loans to officers, etc. are listed as long term assets rather than current assets. If you have borrowed money from the company, then a receivable is showing on your balance sheet. Be realistic, are you going to pay it back within a year? If not, then do not show this receivable in current assets.
Likewise, make sure that the only current liabilities listed are amounts that a company will pay within one year. If you have two or three year service agreements, only those service agreements which renew in that year should be put in current liabilities. Others should go into long term liabilities. Make sure that long term debt is listed as long term rather than in current liability categories. If the company owes you money, is it going to paid back in a year? If not, then put it in long term debt.
If there are figures included as current assets or liabilities that should not be in those categories subtract them out before calculating the current ratio. Likewise, if there are figures that should be included in current as sets or liabilities, add them in before calculating the current ratio.
If you find that your current ratio is decreasing on a month to month basis, the first place to look is at job profitability. This usually is a sign that your jobs are not profitable or that your field employees are not productive. Another reason that the current ratio might decrease is that you purchased assets for cash (i.e. a truck, equipment, etc.). In this case you are trading current assets for long term assets while your liabilities are remaining the same.
Acid Test or Quick Ratio
The acid test is also a measure of liquidity. You calculate this ratio by using figures from the balance sheet. It is calculated:
Current Assets – Inventory
For safety, this ratio should be 0.9 or better. If it is the same as the current ratio, then you are not including an inventory figure on your balance sheet. And, in the contracting business, most companies have inventory. Even commercial oriented businesses have less inventory than residentially focused companies, they still have at least refrigerant inventory on their trucks. The only time that a company wouldn’t have inventory is the case where a parts supplier put parts on consignment (floor plan) in a contractor’s shop and trucks.
The acid test tells you whether you have too much cash tied up in inventory. Bankers know that even though inventory is a current asset, many times you don’t use it within a year. As a result, they want to know whether your company still can pay its bills without relying on selling inventory.
If the acid test is decreasing on a month to month basis, the same issue exists as when the current ratio is decreasing on a month to month basis. Look at the profitability of your jobs and make sure that your pricing is consistent.
Current Ratio to Acid Test
Look at the relationship between the current ratio and the acid test. If the ratio is greater than 2.0 (for example if your current ratio is 3 and your acid test is 1) then you have too much money tied up in inventory. The only time inventory may be at this high level is at the beginning of the busy season. If it isn’t, then either the inventory figure is calculated wrong (when was the last time the company took a physical inventory?)
Or the company must reduce its inventory level and use parts in the warehouse rather than going to the parts supply house when parts are needed.
If the inventory is outdated, then it should be written off (your accountant can help) to reflect the actual inventory levels.
Again remember to include everything that is current assets in the current asset total and everything that is current liabilities in the current liabilities total (see current ratio for a detailed explanation).
Next month I’ll continue the financial ratio descriptions.