Financial Services & Contractors

Healthy balance sheet is good for business

Construction firm owners face a daily onslaught of challenges. They’re in a highly competitive business that goes up and down in response to the strength of the national and local economy. They rely on the availability of skilled labor and a steady stream of working capital to make forward progress on their jobs. Even in the best of times, the weather may conspire against them to thwart progress. It’s a risk-filled enterprise with a relatively high failure rate.

To succeed, contractors need to cultivate good working relationships with two critical resources.

Their financial institution provides term loans to fund the purchase of vehicles and equipment that will be used on their projects. They also provide working capital to bridge the gap between the outflow of expenses and the influx of revenue (cash) to cover them. Their surety company assumes the risk of project completion through bid bonds, performance bonds and payment bonds.

Both of these companies will take a close look at a construction company’s business practices and financial stability before entering into a relationship with them.

There are four key metrics that loom large in the balance sheet analysis.

1. Current ratio

The current ratio measures the degree to which a contractor has the resources to cover financial obligations. This ratio is computed by dividing current assets (e.g., cash, marketable securities) divided by current liabilities (e.g., accounts payable, debt obligations due within one year). The ratio measures the number of times current assets can be used to satisfy current liabilities. Generally, a current ratio of at least 1.20 should be maintained, however, a goal of 1.5 or greater should be targeted to provide a cushion needed to weather more than just routine seasonal lulls.

When calculating the current ratio and working capital turnover, third parties will take a close look at the quality of the assets that are included in the calculation. For example, prepaid expenses are generally excluded from current assets as they represent future expenses. Related party receivables (e.g., loans to owners or amounts due from another related entity) are likewise tossed, as the underlying assumption is that balances from such related parties will not be collected within one year.

2. Working capital turnover

Working capital turnover assesses the relationship between the funds used to support business operations and the revenue that it helps generate. This ratio equals revenue divided by working capital (i.e., assets minus current liabilities). It measures how working capital is utilized to generate profits in the company. This ratio will vary depending on the type, size and nature of a contractor. Too high of a ratio increases sensitivity to cash flow interruptions and the contractor may not have adequate working capital to finance their projects and take them to completion.

3. Equity turnover ratio

Equity turnover ratio is calculated by dividing total revenue by Stockholders’ Equity. It measures how the stockholders’ investment is applied in the company activities. Too high of a ratio may indicate that the company is overextended with too little investment.

4. Debt-to-equity ratio

Banks and sureties may also look at the debt-to-equity ratio (total liabilities divided by total equity) to measure the extent to which outside money supports the business, also known as leverage. Higher ratios indicate that owners are relying more on their creditors to support the business rather than their own equity investment.

When hard work, diligence and strong community ties land a contractor in a position to secure a major project, it may be tempting to forego good financial judgment for the sake of taking advantage of a growth opportunity that may or may not be readily available in the future. Unfortunately, such gambles come with high risk. Unforeseen labor or material shortages, slow receipt of payment, withdrawal of credit, bad weather and a number of other factors could turn an otherwise solid business into a house of cards. It’s a heavy price to pay for a shot at leapfrogging the steady growth curve.