In this week’s episode, Stephen, Wade, and Rob are talking about the key financial ratios that you need to be tracking in your construction business. They cover what the key ratios are, what they mean, and why they’re important.
Topics we cover in this episode include tracking the health of your company, the quick ratio (current assets/current liabilities), what ratios bonding agents are looking for, how a great bonding agent can work with you to help get your bonding up, and what items you can get credit for vs. which items won’t matter to a bonding agent. Lastly, we cover how Profit First can help you with all of this.
Rob Williams: [00:00:00]
Good morning. Welcome to the Contractor Success Forum. I’m Rob Williams
Wade Carpenter: [00:00:10]
I’m Wade carpenter with Carpenter and Company, CPAs.
Stephen Brown: [00:00:12]
I’m Stephen Brown with McDaniel-Whitley Bonding and Insurance Agency.
Rob Williams: [00:00:16]
We’re here driving profits in your contracting businesses.
So today in our Contractor Success Forum, we are talking about the exciting financial ratios, which do affect our bond ratings. Since we just mentioned bonds, Stephen, do you want to start off and tell us a little bit about some of the most important contractor ratios, financial ratios, and why are these so important?
Stephen Brown: [00:00:42]
A financial ratio is a benchmark. It takes two numbers and it divides one into the other and you get a ratio. And all that means is you’re comparing something that is important to somebody. It should be important to you. Some of them are very important to the bonding companies, and really the CPA spearheads that. I’ve never known a good construction CPA that doesn’t explain what their key ratios are and what that means.
And then you want to compare them from year to year. Very few contractors talk about it, but it’s key. If you’re tracking your ratios and you see one get out of line that measures the health of your company, it’s like a heart rate monitor or something. . yeah, it’s kinda important.
The number one ratio is called a quick ratio and it divides your current assets by your current liabilities. Current assets being cash and accounts receivable, anything that’s liquid. Current liabilities would be anything you owe within the next 12 months.
So that ratio is key. And then your working capital to net worth. And then also your sales to gross profit margin helps you determine how much net profits you’re making. And that’s a huge ratio to track.
Rob Williams: [00:01:56]
Speaking of good contractor CPAs, Wade. We have one with us here today, and every day that we’re here, Wade Carpenter, the epitome of the great contractor CPA. Tell us a little bit about what we’re talking here. What is your opinion?
Wade Carpenter: [00:02:17]
Well, we approach it like, these are the things that the bonding company is looking for. And they’re two of the ones that, Stephen just brought up the working capital and your equity are your determinant to how much you can give in bonding. There’s a rule of thumb and it may or may not happen depending on your personal situation, but 10 times working capital or 10 times equity is a little rule of thumb as to how much you can bond.
Stephen Brown: [00:02:44]
As a general rule, a hundred thousand dollars in working capital-that’s current assets minus current liabilities. 10 times that is what you can get a bond for right off the bat. And that changes as you have more experience and you’re moving jobs through your company a little bit faster, but 10 times, which means a hundred thousand dollars working capital will get you a million dollar bond.
Rob Williams: [00:03:05]
And if you have an extraordinary bonding agent that can work with you and get some of these guys to get that experience, which you did for me, Stephen, when I was a contractor, you really were able to get my bonding up with my ratios being about the same.
Stephen Brown: [00:03:26]
Thank you, Rob. I appreciate it very much. The whole thing about financial ratios and benchmark, and they couldn’t sound any more boring, but they’re so important. You can make them what you want to make out of them. It’s just looking at it.
When a physician runs your blood work and there’s a line that goes down the middle and they tell you whether a certain blood profile is something you need to be concerned about or not, this is the exact same thing with financial ratios. And they are so easy when you have the numbers.
You got to have the numbers, you got to track the numbers, or then, you don’t know what this is, but it is so easy once you do it to look at those and have it in front of you. What good does it do having a year-end financial statement prepared by the world’s greatest CPA, if you don’t care what the numbers show?
Wade Carpenter: [00:04:15]
Well, I think accurate numbers, number one, but typically a bond agent will look at it a lot harder than say a banker. If we’re talking about working capital. A bond agent is probably going to throw out, at best half of your inventory, if not all of it, if you’ve got loans to the shareholder, that’s going out the window, those kinds of things.
And there are certain things like prepaid rent, or prepaid insurance. They’re not going to give you credit for that because you’re not going to get the cash back.
Stephen Brown: [00:04:42]
And also, your property and equipment, it’s been depreciated heavily off the books. It may have some value as property that can be sold. The current value of that property, what anyone’s willing to pay for it. But the bonding company doesn’t give you credit for that.
Rob Williams: [00:04:57]
I have one question from the contractor’s perspective of this. How is this done? Because often you just have end of the year statements, especially for the smaller contractors and they had this one number. Throughout the year, how does this work and are you involved in that, Stephen and Wade? Wade, I know you are. But how does that typically work for some people? Do people track it throughout the year? I do have some clients I know that they’re just worried about what happens in July, right, this one day a year. Tell me a little bit about what the contractor’s view is on working with these.
Wade Carpenter: [00:05:36]
The way I approach it, at year end planning, we’re trying to see if we can pump up those ratios and the year end, whenever you’re, if you’ve got a fiscal year end or whatever, that is like that one date in time, those ratios make sense.
And, there are ways to dress some of those things up. I’m just talking about prepaid insurance or say you had prepaid taxes or something, but you had the option of refunding those taxes. If we put that on a income tax refund receivable, a bonding agent is going to give you credit for it, whereas prepaid taxes would not and essentially they’re the same thing. We’re just telling them, get the taxes back and you may have to turn around and pay him later. But those ratios at a certain point in time, definitely they pay attention at the year-end. A lot of times when the market gets tight and people start getting nervous about construction, they’ll require six months and sometimes quarterly statements. And, you do sometimes have to worry about that during the year, but I think Stephen that year-end is the key.
Stephen Brown: [00:06:36]
That’s right. As you’re as you’re pushing your bond program, they want to see that you can prepare in-house financial statements and business balance sheet and income statement that rec reconciles with your with your work on hand.
Because they want to know how much backlog gross profits you have. You get credit for that too. Believe it or not. If you’ve been in business for awhile, they consider backlog gross profit as bank, but cash is King. And we’ve always talked about that from a bonding standpoint , cash is King.
We were talking about ratios like debt to equity ratio. If you owe $300,000 and the equity in your company is a hundred thousand and you’ve got a three to one debt-to- equity ratio. So the way a bonding company sees that is that your creditors own three times more of the company than you do. At what point does that freak out a bonding company, and they say no to bonds? Probably not much higher than that. But what’s considered by the industry as a good ratio might be a three or a two for that particular ratio. So this is something that, that your bond Agent and your CPA can go over with you.
It’s easy to set up and track, it’s so much better to do this. Wade,you were talking about pre year-end financial planning to work on these ratios and do this before the statement’s done for the year. And that’s what we have to work with. And we got to go backwards, for 12 months until the next statement comes out, we got to work with what we’ve got as a bonding agent.
And, pre-planning to get those ratios better is a fantastic thing to do. Usually starting in October, we start pushing all of our clients. Are you talking to your accountant? A lot of times when we see statements come in April May and June, there’s literally nothing going on from the accounting side of the contractor, they’re not doing anything. Most of the time, it’s not the CPA’s fault, it’s that the statement’s late. And that’s just a major note on a bonding company see they’ll take it and continue to give you some bonds. But they have some serious problems with your ability to manage your company when statements come in that late.
Rob Williams: [00:08:44]
I was thinking one thing on here, we’re talking about the ratios being good for the bonding ability, but really, the ratios are good for the contractor because being good for the bonding agent, sometimes the contractor almost gets hostile about that going, I’m tired of trying to make everybody else happy, but they’re there to make the business healthy.
So it’s nice to get more bonding, but don’t forget the real purpose is to make the contractor wealthier. And when things turn down or if there’s a problem, he’s still going to be here if you’ve got those ratios and that’s the real important thing. Stephen and them are here really for your best interest to have that.
Of course they’re protecting the interests of the bonding companies as well, but that rolls over to the contractor being there. The contractor should really work on having that all year long and I can see Wade’s Profit First book over there in the Profit First that he helps you with, and we can help you with, are ways to keep that in line by monitoring your bank accounts throughout the year. And if you have that, then it’s not such a big deal trying to create this end of the year thing because you’re practicing it all year long. I’d love to hear a little bit of talk about how that actually helps the contractor, not just for the bond.
Wade Carpenter: [00:10:14]
Two points on what you said: it is about making a healthier contractor. And so just exactly what Stephen said, that three to one ratio, people start getting nervous if you get higher than three to one debt to equity and you are getting too leveraged out there, and that might be a little different for say a heavy equipment contractor versus a general contractor and versus a subcontractor.
There are other ones like, I typically will say working capital, you probably want to at least 1.4 times current assets, total current liabilities. If you pay attention to these ratios, they can help keep you in line and make sure you’re not getting too far strung out and getting beyond your capacity to grow.
And to go back to what Stephen said about the year end planning. We try to take a three-pronged approach to it because a lot of times we talked in a previous episode about different methods of accounting and you’re probably gonna have a different tax method from your financial statement method.
So if you plan it you can minimize your taxes while maximizing your bonding capacity. And the third prong of this is the cash flow, because if you make a plan in December, that screws up your cashflow in January and February, where you can hardly live, then, that does no good. That’s the way we approach it.
Stephen Brown: [00:11:36]
Like you said, Rob it doesn’t need to be arbitrary. It’s not an us against them type of situation.
The sooner you understand that the more that you can get your money’s worth out of the bonding company that represents you. You can demand more of them. There’s a lot of things bonding and insurance companies give you as consultants from their perspective as to help and analyze the risk that you have every day. And just loss control, safety at a job site. It’s everything. It’s not just something that you wish would go away. Now, OSHA, you wish would go away site, but it’s the same about these financial ratios.
That’s such a good point, Rob. Why would a contractor care? What does it matter? I think this whole forum is about maximizing your profit. We’ve talked about that from day one. How do you maximize your profit if you don’t know where you stand? And then you can get average ratios in the construction industry and you can look at them. And what does that mean? The average American doesn’t have enough savings set aside to retire for more than one year. Is that good? No, that’s a bad average. What do you want the average to be? You set it, you set the standards, you don’t sit around, waiting for a bonding company to come in and go over your ratios and say, we see problems here.
This should be something you and your agent are doing so the meeting with the surety underwriter is nothing but pleasant.
Rob Williams: [00:13:09]
I always enjoyed my meetings with you. And sometimes you’d have the guy from the bonding company there. We’d have a nice peaceful, Mexican lunch or something like that. It was a nice meeting. Appreciate that.
Wade Carpenter: [00:13:22]
There are ratios out there and a lot of times we’ll show them how they stack up. Their RMA puts out ratios and it’s like upper tier and the average and all that stuff, the best ratios you’re going to get are probably from the Construction Financial Management Association, CFM A. They do percentage completion. They do some good statements studies. So there’s a lot of information out there. Even go into your industry trade association. Take a look at it and I think they let them be your guide a little bit.
Rob Williams: [00:13:51]
And even better than that is, most of the contractors are not really going to be aware of the ratios. They’re not typically a financial person. So get with somebody good. Get with your CPA, with your board of directors, whoever your advisors are, your board of advisors and get with those. If they don’t have any answers, they don’t have any knowledge in that, find somebody that can help you. There are lots of resources around there. There’s some people on here that could help you. This is about helping you, not about selling you, but contact somebody. If you don’t have somebody great, find somebody like Wade and Stephen that can help and be involved in that and or call me.
This has been a really interesting show, which could be hours and hours. We don’t have that right now. We have resources and ways you can get that from us- longer, more in-depth seminars or webinars on that. But I really appreciate you guys being here for the Contractor Success Forum today.
Stephen Brown: [00:14:51]
I’m Stephen Brown and I find creative solutions to your bond problems. And my job is to make sure to grease the treads, make sure your bond program’s moving smoothly, and you don’t have any problems. I’m with McDaniel, Whitley Bonding And Insurance Agency in Memphis, Tennessee.
Wade Carpenter: [00:15:09]
I’m Wade Carpenter CPA with Carpenter Company CPAs, and we help contractors nationwide to become permanently profitable and they can find me at CarpenterCPAs.com.
Rob Williams: [00:15:23]
And I’m Rob Williams with IronGate
Entrepreneurial Support Systems, and I am driving profits in your business. IronGateESS.com. And this is the Contractor Success Forum, helping you succeed. We’ll see you on the next show.