For construction companies, it can often be challenging to determine which metrics are most important for effectiveness. Between P&L statements and never-ending balance sheets, it can be easy to get distracted and lose focus of what these numbers mean for the health and longevity of the company – that is what makes financial ratios so important.
As key equations that a construction business can leverage to sort through their numbers and get a clear picture of current performance levels, financial ratios can help predict future outcomes and provide financial planning opportunities that encourage growth or compensate for tough times. In this article, we will look at 5 key financial ratios for construction and the best ways to use them to measure performance against industry-wide statistics.
Current Ratio
Also known as the “Working Capital Ratio”, the Current Ratio is calculated by dividing all current assets by the current liabilities. In most cases, a Current Ratio that is equal to or exceeds 1.0 is considered good; however, some experts may encourage higher ratios of 1.3 or more. If a construction business has a Current Ratio under 1.0, it could be heading towards financial trouble. On the flip side, too high of a ratio may indicate that working capital is not being used efficiently.
Acid-Test Ratio
Often used as an extension of the Current Ratio, the Acid-Test Ratio considers ALL current assets that the construction company may have. This means that cash, cash equivalents, accounts receivables and short-term investments are divided by current liabilities. A ratio between 1.1 and 1.5 is recommended by most financial experts and could signify the ability to pay for current liabilities without having to convert available assets like inventory to cash first.
Debt-to-Equity Ratio
Better viewed as a leverage ratio, the Debt-to-Equity Ratio measures the growth of a company that has been financed through debt. Finding this number is as simple as dividing your debt by equity to determine a balance. If the Debt-to-Equity Ratio is below 2.0, that is generally considered good and anything higher than that could mean the company has built too much debt trying to stimulate growth. Ultimately, this could also hinder the ability to obtain more loans.
Equity Turnover Ratio
The Equity Turnover Ratio is a common efficiency ratio that looks at how efficiently a business may be using its current equity or value to drive revenue for the construction business. To find the Equity Turnover Ratio, construction businesses should divide sales by total equity. Unlike other financial ratios, an acceptable range for this metric could be anything below 15.0. When compared with other financial ratios, this provides a broad financial view for a construction business.
Working Capital Turnover Ratio
Another efficiency ratio that can assess how well a company can manage its debts and assets and learn how they are generating revenue is Working Capital Turnover Ratio. Essentially, this ratio will explain what level of company value is free for operations and can be calculated by dividing sales by working capital. Any ratio exceeding 30 can show the need for more working capital in the future and not enough working capital is available to support current sales growth.