Liquidity Ratios for Contractors (Part 2)

May 19, 2020

female contractor holding notepad with male contractor holding jobsite sketch outside

image credit: goodluz/shutterstock.com

Last week we explored the types of financial ratios available to the Contractor and began investigating liquidity ratios. This week, we will continue our discussion on liquidity ratios. We will be referring back to our XYZ Company example from last week.

As a reminder, the company had the following assets and liabilities on their balance sheet:

Current Assets= $248,210

Current Liabilities= $123,850

Cash = $12,800

Accounts Receivable - $150,860

 

The Acid Test Ratio

The acid test ratio, or quick ratio, measures the ability of a company to cover its current liabilities with its liquid assets (i.e. cash, marketable securities, accounts receivable, and less doubtful accounts). Any inventory the Contractor may have is not included in this calculation, as it can be “slow moving” and not readily converted to cash. This ratio is determined by:

Liquid Assets/ Current Liabilities = Acid Test Ratio

Let’s explore the acid test ratio with our XYZ Company example:

Liquid Assets ($163,660) = Cash (12,800) + Accounts Receivable ($150,860)

$163,660 / $123,850 = 1.32

Acid Test Ratio = 1.32 to 1

This means that the example firm can pay all its current liabilities simply by using its cash and converting its accounts receivable into cash. Most financial analysts agree that the acid test ratio should be in the range of 1.00-1.50 to 1.

Contracting firms with an acid test ratio of less than 1.00 to 1 may not be able to meet current obligations without converting inventory or other assets into cash, or financing through debt. If the acid test ratio is in excess of 1.50 to 1, the firm might be overcapitalized and should consider investing the excess in other profit-producing ventures or attempt to maximize cash turnover through increased sales volume. Within a range of .1.0-1.5 to 1, the contractor should be able to meet current obligations fairly easily.

 

Working Capital

Working capital is a measure of the funds available for future operations, since it is the excess left after taking care of all current obligations. The calculation for this is:

Current Assets – Current Liabilities = Work Capital

Going back to our XYZ Company example:

$248,210 - $123,850 = $124,360

Their working capital would be $124,360, or the net assets available to the Contractor for investment in operations to generate revenues and profit.

 

Current Assets to Total Assets Ratio

The relative liquidity of a company’s assets is important to most financial analysts. The current assets to total assets ratio is used to measure relative liquidity. It’s determined by:

Current Assets/ Total Assets = Relative Liquidity

Once again, going back to our XYZ Company, let’s assume the total assets of the company as shown on the balance sheet are $302,160. The equation would be as follows:

$248,210/ $302,160 = .82 to 1 ratio

This ratio indicates that roughly 82% of the company’s assets are fairly liquid. A ratio of less than .60 to 1 may indicate an excessively high investment in fixed assets, whereas a ratio of greater than .80 to 1 normally indicates that management has decided not to invest too heavily in equipment and vehicles. Since various construction trades require greater or smaller investments in equipment, the ratio range is a general guideline.

As a company Owner, it’s important that you understand your balance sheet and the financial health of your company. Knowing your liquidity ratios will help direct the growth of your company. For additional guidance on ratios, and to help determine your ability to bid on larger projects, reach out to TSIB today and let us help you achieve your profitability goals!

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Written by The TSIB Team