Most financial statements provide a basic overview of income, expenses, and profit. While this information can help contractors and business owners make better decisions, these details do not convey the complete picture of a construction company’s financial health. Combining balance sheet details with financial ratios can provide better insights into your company’s current position and what it may look like in the future. We will share several financial ratios and how each of them can guide your decision-making.
What are Construction Financial Ratios?
Construction financial ratios give business owners a different way to analyze their finances. These ratios dive deeper into the financial well-being of your company that you can’t get by gleaning your balance sheet. It’s easy to get overwhelmed by analytics and various ratios, but narrowing your focus to a few important metrics will give you pertinent information in a short timeframe.
Construction Financial Ratio Categories
Construction companies can review many financial ratios, but you don’t want too much information. Too many data points can make it more challenging to decipher critical insights. Focusing on these categories will help you prioritize the core elements of your business.
Liquidity Ratios
Liquidity ratios determine if your company can handle short-term debts. In addition, they determine if you have enough cash flow and how quickly you can convert assets into capital if necessary. Business owners can use these numbers to confirm confidence or make adjustments that increase their margin of safety.
Profitability Ratios
Profits are the foundation of every healthy business, as profitable construction companies can scale much more quicker and accumulate more resources. These ratios reveal the percentage of revenue you keep and the return on your investments.
Leverage Ratios
Many businesses use debt to finance equipment purchases, payroll, and other investments. Strategically incurring debt can help you grow your business and get new clients, but some companies collapse because they take on too much debt. Leverage ratios provide insights into your ability to repay financial obligations and how much your company relies on debt.
Efficiency Ratios
Using your assets more efficiently can increase your revenue and help your company expand. Efficiency ratios measure how you use resources to grow your business and how quickly you obtain additional funds.
Key Construction Financial Ratios
Every construction ratio belongs to one of the categories we discussed earlier. The following metrics have higher importance and should become essential elements of your financial planning.
Current Ratio
The Current Ratio measures your assets against your liabilities. Construction companies can assess if they can cover their current liabilities with their current assets and determine if they have a reasonable margin of safety. Construction companies should aim for a Current Ratio above 1, which would indicate a company has enough resources to cover all of their current liabilities if they became due today. However, an excessively high Current Ratio can indicate the construction company can better allocate its capital towards expansion.
Quick Ratio
The Quick Ratio is similar to the Current Ratio, but it only counts liquid assets. You can consider cash and cash equivalents when listing your assets, but inventory and equipment will not go into this calculation. This is because inventory and equipment take more time to become liquid, and you may not have enough time to sell those assets to pay your current liabilities if they become due today. Therefore, you should aim for a Quick Ratio above 1, similar to the Current Ratio.
Debt-to-Equity Ratio
The Debt-To-Equity ratio determines how much of your company’s growth comes from debt. It also reveals the degree to which equity drives your company forward. Debt and equity can help your company grow, but too much debt can become burdensome. You should aim for a Debt-To-Equity ratio above one but no more than 2. A higher Debt-To-Equity ratio can make additional financing more difficult to obtain, and you may get stuck with higher interest rates. This can become problematic for companies that rely on debt for funding. Construction companies can assess their current debt and prioritize paying it off or depending on equity to make their Debt-To-Equity ratios more attractive.
Working Capital Turnover Ratio
This ratio measures how much revenue you earn from every dollar invested. Construction companies can set a benchmark and examine their expenses. Assessing which raw materials yield the highest profits can inspire where you invest your dollars in the future. While a Working Capital Turnover Ratio above 1 indicates you make more than you spend, construction companies should establish higher goals for this ratio. A Working Capital Turnover Ratio of 1.0 implies your company is barely breaking even on its returns. Companies with high proportions (i.e., 30 or higher) may want to accumulate more working capital to gain more market share.
Equity Turnover Ratio
The Equity Turnover Ratio focuses on equity instead of capital. Just like the Working Capital Turnover Ratio, total sales is the numerator. A higher ratio is better for your business, but an Equity Turnover Ratio above 15 can indicate growth issues. Construction companies can review the Equity Turnover Ratio to see how effectively they use equity. A low Equity Turnover Ratio can inspire management to reassess how they use equity so they can improve the ratio.
Things to Consider When Making Financial Decisions Based on Construction Financial Ratios
Construction financial ratios can reveal notable insights about your company and guide decision-making. You should consider these factors when analyzing financial ratios.
Ratios Are Oftentimes Better Than Raw Financial Data
Raw financial data is helpful, but financial ratios give better insights into your company’s growth and ability to manage financial obligations. You can measure progress in specific areas of your company instead of looking solely at changes in income and expenses.
Ensure All Inputs are Accurate
An inaccurate input will give you flawed data points and result in the wrong decisions. Make sure you use the correct inputs before making business decisions based on the data. It’s vital to keep your raw financials and ratios organized, and keeping them on a spreadsheet will make them easier to reference.
Know When and How to Use Each Ratio
Each ratio fits into one of four categories: liquidity, profitability, leverage, and efficiency. Determine which category you need to prioritize and look for ratios within that category to guide your analysis.
Use Comparable Competitors as Benchmarks
Knowing the financial ratios of other competitors will reveal outperformance, underperformance, or neutral results. Construction is cyclical, and some years will yield better results for the industry than others. Therefore, knowing how your competitors are performing will give you a better understanding of your company’s future prospects.
Use Results to Explore Potential Opportunities
Construction companies with high Quick Ratios and modest Working Capital Turnover Ratios can consider making additional investments. A high Quick Ratio indicates more financial flexibility, and deploying extra capital into the business can increase your sales if you maintain the Working Capital Turnover Ratio. A slight uptick in the Working Capital Turnover Ratio can increase your sales and help you get more mileage out of your funds.
Correct Problematic Trends ASAP
Financial ratios can reveal weaknesses in construction companies. These weaknesses can become significant problems if they remain unaddressed. Companies with Quick Ratios under one should prioritize cutting down debt. The low Quick Ratio can become problematic as more debt becomes due, especially if the construction company experiences a short-term slowdown. Correcting minor problems before they become significant can increase a construction company’s sustainability.
