Frank Blau
Contributing Writer

Contractors often ask me to help scrutinize their business. One of the most important questions I ask is, “What if…” then I try to provide some answers.

Doing so requires a look at the company’s balance sheet and three key ratios derived from the balance sheet. These ratios give a good indication of your company’s “staying power” in any economic climate. Since many contractors report that business is slow right now, this may be just the time to tackle this project.

The balance sheet tends to be a forgotten statement in most businesses – but not so for bankers. They spend a lot of time studying balance sheets, and for very good reasons. A balance sheet tells at a quick glance just how solvent a firm is at any point in time.

One side of the balance sheet are assets – what the business owns and uses to generate sales. There can be more categories but in the simplest terms let’s pay attention to the two most important ones:

1. Current assets are what you own that will turn into cash within one year, such as accounts receivable and inventory, plus of course cash on hand.

2. Fixed assets are what you own that has value but which cannot be readily turned into cash in one year, such as buildings and vehicles.

The other side of the sheet shows where all the dollars came from to buy all the assets.

This includes what the business owes to people who loaned the business money, called liabilities, and what it owes to investors – in our industry, the owner for the most part. This is recorded as net worth.

Liabilities include current liabilities – what the business owes that must be paid off within one year – and long term liabilities – what the business owes that has a longer pay period, again such as property or vehicles.

Net worth encompasses capital stock, funds invested when the business was started and retained earnings, i.e., all the net profit from operations to purchase assets to grow the business.

The balance sheet gets its name from the fact that it must balance. That is, for every dollar put into assets, someone – either investors/owners or creditors – had to supply that dollar. If you are practicing do-it-yourself accounting balance, it’s because you are mis-categorizing or failing to count some assets, liabilities or net worth.

Your balance sheet was born on the day your business was founded and carries forth like a financial photograph of the enterprise at a specific point in time. The key question is what can you do with the information in this financial photo?

The answer lies in three key ratios that can be calculated from a balance sheet.

1. Current Ratio – This is the fundamental measure of a firm’s solvency. You simply divide your current assets by current liabilities.
2. Quick Ratio – Here you take your accounts receivable, plus cash on hand, and divide them by current liabilities. Also referred to as the “acid test,” the quick ratio measures the liquidity of the company, or its ability to generate cash quickly. This quick cash means one can pay bills without having to rely on sale of inventory.
3. Debt-to-net-worth ratio – This is also called the “banker’s ratio.” It measures a firm’s ability to withstand financial adversity or risk over the longer term. This ratio is calculated by dividing total liabilities by the firm’s net worth.

What do these ratios mean? The chart shows the balance sheet ratios for a PHC contracting firm that has increased sales from $600,000 in 2002 to $1 million in 2004.

Sounds impressive, but a banker might point out that the increased revenues were bought at the price of some serious debt accumulation. The trends in solvency and liquidity are moving downward and the debt-to-worth ratio is moving upward – bad signs.

Dollars & Sense: In dollar terms, this contractor’s current ratio means that for every dollar of current liabilities in 2004, the firm had $1.10 in current assets – i.e., money due to come in – with which to pay off those liabilities. While that may sound okay, most bankers would judge it too close for comfort. Keep in mind that the current ratio is based upon assets that include accounts receivable and inventory. If business drops off or this company gets burned by one or two big accounts, this firm might have considerable trouble paying its debts.

Bankers like to see a 2:1 current ratio – for every dollar in current liabilities, the company has $2 in current assets. Truth is, they rarely see a 2:1 ratio in our industry. While they might cut this company some slack in that area, what would surely disturb its banker is seeing the downward trend of the current ratio from 1.4 to 1.1 over the last three years. This firm is clearly getting weaker in its ability to satisfy current obligations.

The quick ratio, which is also deteriorating, tells us that for every $1 of current liabilities, this contractor has $.30 in cash and accounts receivable to pay them with. Here bankers like to see 1:1 ratio – for every $1 in current liabilities, there should be $1 in cash and accounts receivable.

The third ratio gives us a measure of the funds invested by the owner(s) in relation to the funds borrowed to finance the business. Our example shows that for every $1 of net worth (funds invested by the owner), this contractor has $3.60 in liabilities (funds borrowed from his mother-in-law or attorney who think PHC contractors make a ton of money!).

We can easily see that over the past three years this firm has been using borrowed money to finance its business growth, and this means the firm has become increasingly risky. Why? Because those borrowed funds must be repaid – even if sales slump and profits disappear.

Call to Action: These three measures of stability, each derived from basic balance sheet information, can give you an important indication of the overall financial health – or sickness – of your business. Take these steps to put your own monitoring program in place.

1. Put your balance sheet statements in a spreadsheet format with data from each year marked in adjoining columns. This makes calculations and comparisons a lot easier.
2. Construct a “balance sheet ratio score card” such as the one used in this article. This box is basically a simple spreadsheet, with each category on a separate line and the data for each year in a separate column.
3. Calculate your ratios for each year, putting the ratios into words, i.e., “For every dollar of…”.
4. Evaluate, evaluate! Does your ability to pay bills and generate cash flow look satisfactory as things stand? Or does it need to be improved? Is your business relying too much on borrowed money? Or could you afford more debt?
5. Take action when danger lurks. Maybe you need to consolidate debt, or make bigger payments, or at least put a halt to more borrowing. A wait-and-see attitude won’t help.

Not sure what to do? Talk with your banker or CPA – but make sure the ones you deal with are construction industry oriented. Ultimately, it’s your business and you are the one who needs to take positive control of your financial situation.