Know the Numbers of Your Business

For many contractors, one of the most challenging things about operating a business is managing the finances. How can understanding the numbers help you to make the best decisions about pricing, purchases, hiring, and what jobs to take? Often we are accustomed to looking only at the income statement which identifies our sales, costs and profits. But, what can we learn by looking at the balance sheet? We spoke with Arthur Felderstein, a Philadelphia based CPA with a strong knowledge of the contracting industry. Art explained how you can use information from your balance sheet to understand a number of key indicators of the health of your business.

According to Art, the most important thing you can do to ensure financial health is to set up your books correctly and maintain them on a regular basis. If you don’t do this, your information will be out of date or just plain wrong, and you are in danger of making bad decisions based on this information. This is where it is critical to consult with an accounting professional to make sure that your accounting system will give you the information you need. Once you are sure that the numbers are good, you can begin to look at your Balance Sheet Metrics.

Why Should You Care About Balance Sheet Metrics
Balance sheet metrics provide important early warning signs which can alert you if your business is not on a strong financial footing. By identifying such problems early, you can deal with them before they become big problems. With the help of these metrics and your accountant, you can also identify potential strategic issues which may be contributing to your financial problems.

One example that Art discussed was a client in the HVAC industry.  This client was very proud of the fact that he was the main HVAC contractor for a major builder. In order to keep this business, Art’s client always priced his jobs very low since the builder only cared about price. After working with Art and looking at his metrics, this contractor learned that he was pricing himself right out of business. So, he changed his strategy and began to look for smaller jobs where the customer was less price sensitive. Now, his business is thriving.

How to Calculate Balance Sheet Metrics
A key step to attaining an understanding of the current and long term financial state of your business is to look at the numbers on your balance sheet. There are several different metrics that can act as a barometer for where your business is heading.

1. Current Ratio
The Current Ratio, current assets divided by current liabilities, is a measure of your business’ ability to meet current financial obligations (i.e. credit card bills, payroll, loans, and rent). A healthy business should have a Current Ratio greater than one which means that you have more assets than money due. If your current ratio is below one, it is an indicator of potential short term and even long terms problems with your financial health.

Example of a healthy business:
  Current Assets
110,000
 
  Current Liabilities
90,000
 =  1.67
Example of a business with a potential problem:
  Current Assets
150,000
 
  Current Liabilities
180,000
  =  0.83

2. Quick Ratio
The Quick Ratio is a variation of the Current Ratio and is sometimes called the “Acid Test” because it is a more precise indicator of your business’ ability to meet its current obligations. Instead of looking at all current assets, the Quick Ratio looks only at cash and cash equivalents. It is a more conservative way of looking at the dollars available to pay next month’s bills. If your Quick Ratio drops below one, it indicates that you will have trouble meeting your financial obligations in the short term.

Example of a healthy business:
  Cash + Equivalents
110,000
 
  Current Liabilities
90,000
 =  1.22
Example of a business with a potential problem:
  Cash + Equivalents
150,000
 
  Current Liabilities
180,000
  =  0.61

3. Days Receivable
Days Receivable is a measurement of how many days it takes for your business to collect payments from your customers. If your Days Receivable is greater than your payment terms, then you are acting as a banker for your customers. This is an important indicator that you need to look at your collections policy. Calculate Days Receivable in the following way: find your average day’s sales by dividing annual net sales by 365 days. Then divide your accounts receivable balance by the average day’s sales to get days receivable.

Days Receivable Example:
  Annual Net Sales
200,000
 
  365
365
 =  547.57
 
  Accounts Receivable Balance
32,000
 
  Average Days Sales
547.57
  =  58.44 days

Click here to link to a simple online Days Receivable calculator.

4. Working Capital
Working Capital, another way of looking at the liquidity of your business, is defined as current assets minus current liabilities. Working Capital tells you how well you can meet your current obligations and how much will be left over for further investment. If your Working Capital is negative, you can cover this shortage by going into a line of credit in the short term. However, negative Working Capital over a period of time means that your business has a serious problem.

Example of positive Working Capital:
  Current Assest – Current Liabilities  
  150,000 – 90,000 = $60,000
Example of negative Working Capital
  Current Assest – Current Liabilities  
  150,000 – 180,000 = -$30,000

Benchmarks
Another way of understanding the meaning of balance sheet metrics is to compare them to established benchmarks. In the contracting industry, published statistics are available which define the appropriate level of these metrics by geographic area, size of company, amount of assets, etc. By comparing your numbers to these benchmarks, and understanding why your numbers differ, you can gain a firm hold on the financial health and performance of your business. Your accountant should be able to help you locate the right benchmarks and to understand how your numbers compare.

For more information on using your financial data to help your business, see our article, Pricing for Profit, from the February issue of Weinstein News and Tips.

Arthur Felderstein is a certified public accountant as well as a certified valuation analyst and certified fraud examiner. He has provided accounting, business advisory and tax services to business entities and individuals throughout the Metropolitan Philadelphia area for over twenty years. He has done a lot of work in the construction trade. To learn more about Art, check out his Web site at http://www.felderstein-cpas.com.