With the economy showing signs of improvement, many contractors are beginning to pursue growth opportunities more aggressively. As this trend continues, it is important to carefully manage both the financial and operational aspects of the business.
According to construction CPAs from Wipfli/Bauerle, business owners and financial professionals should keep a close eye on certain key performance indicators (KPIs). These KPIs will give them a reading on their companies’ health and performance.
Here are some of the most closely watched KPIs, grouped into five general categories. Bear in mind these KPIs should be viewed collectively — no single metric gives you the whole picture.
1) Profitability – Profits are generally derived from two sources. Operational profit is derived directly from your company’s construction activities, while non-operational profit is derived from independent opportunities like improved cash management, savings from self-insurance programs and income from other profit centers.
There are three primary KPIs for measuring profitability:
Gross Profit Margin = (Revenue – Direct Cost of Work)/Revenue. This number indicates the percentage of sales revenue that is not paid out in direct costs (costs of sales). It is an important statistic that can be used in business planning because it indicates how many cents of gross profit can be generated by each dollar of future sales. Higher is normally better (the company is more efficient.)
- Net Profit Margin = (Gross Profit – Indirect Costs)/Revenue. This is an important metric. In fact, over time, it is one of the more important barometers that we look at. It measures how many cents of profit the company is generating for every dollar it sells. Track it carefully against industry competitors. This is a very important number in preparing forecasts, and the higher the number the better.
- Return on Equity = Net Profit/Owner Equity. This measure shows how much profit is being returned on the shareholders’ equity each year. It is a vital statistic from the perspective of equity holders in a company, again, the higher the return the better.
How much profit should a construction business generate? The answer depends on many factors, including your company’s size and age, your particular trade or areas of specialty, and local economic conditions.
2) Cash flow – Cash is the lifeblood of your business. You need sufficient cash to meet payroll, pay for materials and supplies, reimburse subcontractors and meet general expenses, while still meeting lenders’ and sureties’ liquidity requirements.
A broad cash flow reading is the cash demand period. It is driven by three balance sheet accounts: accounts receivable, accounts payable, and overbillings/underbillings:
- Cash Demand Period = Average Days Required to Fund Operations – Average Days to Pay Creditors. This is essentially the difference between the length of time it takes to receive payment for work and the time you take to pay your creditors.
- Days in Accounts Receivable = 365/(Revenue/Accounts Receivable). Top-performing contractors reduce this by managing client relationships and collections carefully. This number reflects the average length of time between credit sales and payment receipts. It is crucial to maintaining positive liquidity. The lower the better.
- Days in Accounts Payable = 365/(Direct Cost/Accounts Payable). Prudent use of trade credit helps maintain flexibility. This ratio shows the average number of days that lapse between the purchase of material and labor, as well as payment for them. It is a rough measure of how timely a company is in meeting payment obligations. Lower is normally better.
- Overbillings/Underbillings = (Billings – Earned Revenue)/Earned Revenue. Aggressive billing practices can help reduce underbilling for work performed and promote prudent overbilling.
3) Liquidity – Liquidity indicators measure your company’s ability to meet short-term obligations. They are particularly important to your financial partners and creditors.
- Current Ratio = Current Assets/Current Liabilities. This compares the availability of current assets to satisfy current liabilities. Generally, this metric measures the overall liquidity position of a company. It is certainly not a perfect barometer, but it is a good one. Watch for big decreases in this number over time. Make sure the accounts listed in “current assets” are collectible. The higher the ratio, the more liquid the company is.
- Working Capital Turnover = Revenue/(Current Assets – Current Liabilities). Working capital measures the funds available to invest in operations to generate more revenue. Working capital turnover measures how aggressively these funds are being used to generate income.
4) Leverage – Financial leverage indicators directly affect your company’s risk profile as well as its ability to repay debts and take advantage of new opportunities.
- Debt to Equity = Total Liabilities/Owner Equity. One of the most important financial ratios, this measures how highly leveraged your company is. A higher ratio creates additional risk. A ratio of 3.0 or lower is usually desirable.
- Revenue to Equity = Revenue/Owner Equity. A high ratio indicates you have less flexibility to absorb project losses.
5) Forecasting – Top performers carefully monitor work in the pipeline, and project sales and revenue at least one year out.
- Backlog to Equity = Backlog/Owner Equity. Too little backlog and your company stumbles; too much backlog and you’re overwhelmed.
These KPIs should be tracked over time in order to spot trends. Monthly readings are recommended for many indicators — especially as you pursue a change in strategy — to get an early reading on whether you are gaining or losing ground.
At Wipfli/Bauerle, our construction CPAs can help you compare your company’s KPIs to your peers and to industry benchmarks. Call us at 303-759-0089 to schedule an appointment.