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Financial statements report the condition of a construction company and serve as a basic measurement of the company’s strength or weakness. To Creditors like Banks and Sureties, these statements are an essential underwriting tool when making decisions like bonding to support the Contractor. The ability to read and understand these statements is an extremely valuable management tool.
Among the financial statements available to the Contractor and its Creditors, the balance sheet shows a company’s financial position at a specific point in time. On a certain date, all accounts are “locked,” and their balances—assets, liabilities and Owner’s equity— are gathered in a single statement to show the company’s condition at that time. It represents, in dollars and cents, the items that can be used to expand or limit future operations.
Key Financial Ratios
If you understand the balance sheet, ratio analysis can then be used to determine the relative financial strength of a contracting firm. The key financial ratios that measure different aspects of the firm's financial status are:
- Liquidity Ratios measure the firm’s ability to pay its obligations as they come due and Creditors pay particular attention to these numbers.
- Profitability Ratios measure the ability of the firm to generate income from operations and thus increase the equity of a company.
- Activity Ratios measure how effectively a firm is using its assets.
- Capital Structure Analysis measures a company's ability to manage debt and demonstrates the way a company has chosen to finance its operations.
While all these ratios are important, below focuses on an exploration of liquidity ratios.
The Current Ratio
The current ratio is among the most frequently used financial measures for the typical Contractor. This ratio is used to determine the number of times current liabilities can be paid by current assets. The calculation for this is:
Current Assets / Current Liabilities = Current Ratio
As an example, XYZ Company has the following assets and liabilities on their balance sheet:
Current Assets= $248,210
Current Liabilities= $123,850
$248,210 / $123,850 = 2
The Current Ratio in this example for XYZ Company is 2.00 to 1.
Generally, banks and bonding companies indicate that they use a 2.00 to 1 current ratio as the minimum standard. This standard means that a company would need to have, at a minimum, twice as much in current assets as their current liabilities. However, this standard is not entirely applicable to contracting since, by the very nature of the business, Contractors have considerably greater operating opportunities without maximizing current assets.
Contractors normally have a relatively small portion of their total assets invested in material inventory, as compared to the relatively high portion needed in some other industries. A current ratio of 1.50 to 1 may be adequate for many Contractors. With a current ratio of less than 1.50 to 1, the company may have difficulty meeting current obligations. In other words, it may be undercapitalized or the company may have too much of its capital invested in fixed assets.
On the other hand, while a Contractor with a current ratio of more than 2.00 to 1 shows outstanding financial strength, it may have become inefficient and stagnant. When the current ratio approaches or exceeds 2.50 to 1, the company is likely overcapitalized. In such cases, management should consider investing the excess current assets in other profit-generating ventures or expanding its contracting business.
The current ratio does not consider the liquidity of the components of current assets. For example, a Contractor whose current assets consist mainly of cash and receivables would be “more liquid” than a Contractor whose current assets are composed primarily of inventory. For this reason, the Acid Test Ratio is suggested as a more reliable measure of relative liquidity.
Join us next week as we explore the Acid Test Ratio, working capital, and total asset ratios. If you have any questions until then, reach out to TSIB today!