Please Note: This is part of a series of articles titled Accounting and Bookkeeping Principles for Contractors
Written by James R. Leichter
Using Financial Ratios and Key Performance Indicators to Monitor Your Business
In baseball, pitching managers use statistics to help them make important decisions; such as which pitch to throw, to what player, and under which circumstances. Likewise, construction business managers use KPIs and ratios to make informed business decisions.
Key Performance Indicator (KPI) is a term for a type of measure of performance. Financial ratios are used to gauge the overall financial health of an organization.
There are many types of KPIs and financial ratios. The most popular are solvency, profitability, and efficiency. Solvency ratios gauge how easily an organization can pay its bills. Profitability ratios judge a company’s ability to generate a profit. Efficiency ratios analyze such things as how well a company utilizes its working capital.
All companies should pay attention to several key ratios including Quick Ratio, Cash to Current Liabilities, Collection Period, Sales to Inventory, Gross Profit, and Sales per Employee.
If you manage a construction company, you might wish to keep a close eye on Owner’s Equity, Cash to Current Liabilities, and Sales to Total Assets.
There are specific ratios for key business segments. For instance, if you manage a service department, you should pay attention to sales to technician labor, un-billable time, average amount per invoice, conversion rates, service agreements sold, and technician callbacks.
Each type of KPI and ratio mentioned in this article is described below. We have included recommendations for you to consider when evaluating or benchmarking your company. These recommendations depend heavily on the industry segment and should be considered only as a rough guideline for you to follow.
Return on Sales (AKA: Net Profit Margin) measures the before tax profits on the year’s sales. Our recommendation is 5% or greater.
(Net Profit Before Taxes / Net Sales) x 100
Return on Owner’s Equity (AKA: Return on Investment) measures the ability to realize an adequate return on the capital invested by the owners. Our recommendation is 25% or greater.
(Net Profit Before Taxes / Net Worth) x 100
Return on Assets matches net profits after taxes with the assets used to earn such profits. A high percentage rate can tell you the company is well managed and has a healthy return on assets. Our recommendation is 15% or greater.
(Net Profit After Taxes / Total Assets) x 100
Acid Test (AKA: Quick or Liquid Ratio) measures the extent to which a business can cover its current liabilities with those current assets readily convertible to cash. Our recommendation is 1.35 or greater. (Cash + Accounts Receivable) / Current Liabilities
Cash to Current Liabilities measures the company’s ability to handle an absolute worst case scenario where liabilities must be satisfied immediately. We generally recommend a ratio of 1. In other words, you have $1.00 in cash to pay off $1.00 of liabilities.
Cash / Current Liabilities
Sales to Total Assets measures the percentage of investment in assets that is required to generate the current annual sales level. If the percentage is abnormally high, it indicates that a business is not being aggressive enough in its sales efforts, or that its assets are not being fully utilized. A low ratio may indicate a business is selling more than can be safely covered by its assets. Our recommendation is generally 5 to 7.
Net Sales / Total Assets
Sales to Inventory (AKA: Inventory Turnover) typically applies to companies that rely on inventory to help create sales. When this ratio is high, it may indicate a situation where sales are being lost because a company is under-stocked and/or customers are buying elsewhere. If the ratio is too low, this may show that there is not a lot of demand for what you have in stock. Our recommendation is generally 6 to 8.
Annual Net Sales / Inventory
Collection Period (AKA: Average Age of Accounts Receivable) is helpful in analyzing the “collectability” of accounts receivable, or how fast a business can increase its cash supply. While each industry has its own average collection period, more than 10 to 15 days over terms should be of concern. Our recommendation is 40 or less.
(Accounts Receivable / Sales) x Days in Period
Sales to Total Labor Expense indicates how much of your total sales revenue is consumed by all payroll and labor related expenses. The lower the number the better, because it suggests that you are efficiently using employees to create and manage sales. Our recommendation is .3 or less.
Payroll / Sales
Sales to Technician (Field) Labor indicates how much of your total sales revenue (income) is consumed by payroll and labor expenses related to the field (usually sales, technicians and installers). The lower the number the better, because it suggests that you are efficiently using your employees to create sales. Our recommendation is .2 or less.
Field Labor COGS / Sales
Key Performance Indicators
This is the amount of hours that were paid but not billed to a job. A service department should bill out at least 40% of its total labor hours while construction should be 90% higher.
Average Amount Per Invoice
Obviously your goal depends largely on the type of work you are doing and the industry you are in. Be sure to set standards for your service and installation department.
Conversion Rate to Repair
This KPI indicates how many service calls (trip charges) were made versus how many of those trips resulted in an actual billable repair.
Conversion Rate to Service Agreement
Indicates how many service calls were made versus how many of those resulted in the sale of a service agreement. If you’re in the service business, you should have approximately 300 SAs per billable employee.
Net sales minus the cost of goods and services sold (direct expenses). Service work should yield a GP of 70% or higher while heavy construction can be 20%. One of your manager’s most important responsibilities is to protect profit margins on labor and materials.
A “callback” can be defined as return visit to correct an improper repair that cannot be billed. A good service department should have less than 2% of its service calls result in a callback.
Most KPIs and financial ratios are calculated using information from your income statement and balance sheet. Good industry specific accounting software will do the calculations for you and warn you of problems. Which numbers you should examine depends on what business segment you manage. You may need to develop other KPIs and ratios that are not covered here.
Keep in mind that financial ratios and KPIs are only as accurate as your least accurate financial numbers. These ratios may mean nothing if your company does not practice good quality bookkeeping that is timely and substantially accurate. You must practice accrual accounting for many of these values to be meaningful. Departmentalization of your accounting data is also highly recommended.
Knowing your numbers is a crucial element of being a business manager. With a careful compilation and analysis of KPI’s and ratios, you will be able to manage your business by the numbers, just like the business of baseball does.
James R. Leichter Bio
James is a lifelong contractor and nationally recognized expert in contracting management. He has consulted with businesses all over the USA and has served as an expert witness. You can visit his website at www.mrhvac.com