Know Your Ratios

By Matthew Nash, CPA

The construction industry is unique and complex, with its own set of financial challenges and opportunities. Understanding the financial health of a construction company is crucial to making informed business decisions. Financial ratios are powerful tools that provide valuable insights into profitability, liquidity, solvency, efficiency, and project performance.

Ratios are resources to more than just investors, shareholders, and management teams. They are also used by lenders and creditors to evaluate credit risk, by contractors and subcontractors to gauge the financial health of potential partners and ensure the ability to meet obligations, and by regulatory agencies to ensure compliance with industry standards and regulations.

This article highlights key financial ratios tailored specifically to construction companies, which are used to analyze a construction company’s stability and operational efficiency.

Profitability Ratios

Gross profit margin indicates how efficiently a construction company is managing its direct costs associated with projects. A higher gross profit margin suggests that the company is effective in controlling project costs and pricing. Calculation: gross profit margin = gross profit divided by revenue multiplied by 100.

Operating profit margin measures the percentage of revenue that remains after covering operating expenses, excluding interest and taxes. The operating profit margin reflects how well and how efficiently a company manages its core business operations. Calculation: operating profit margin = operating income divided by revenue multiplied by 100.

Matthew Nash

“Ratios are resources to more than just investors, shareholders, and management teams. They are also used by lenders and creditors to evaluate credit risk, by contractors and subcontractors to gauge the financial health of potential partners and ensure the ability to meet obligations, and by regulatory agencies to ensure compliance with industry standards and regulations.”

Net profit margin shows the percentage of revenue that remains as profit after all expenses, including interest and taxes, have been deducted. A strong net profit margin indicates overall profitability and effective management of both operational and non-operational expenses. Calculation: net profit margin = net income divided by revenue multiplied by 100.

Liquidity Ratios

Current ratio assesses a company’s ability to meet its short-term liabilities with its short-term assets. For construction companies, which often deal with significant short-term obligations due to project timelines and payment cycles, maintaining a current ratio above 1.0 indicates that the company could pay off its liabilities if they become immediately due. Calculation: current ratio = current assets divided by current liabilities.

Quick ratio, or acid-test ratio, provides a stricter measure of liquidity by excluding inventory from current assets. Given that construction companies may have substantial inventory tied up in ongoing projects, the quick ratio offers a clearer picture of the company’s ability to cover immediate obligations. Similar to the current ratio, a good quick ratio should be higher than 1.0. Calculation: quick ratio = current assets minus inventory divided by current liabilities.

Solvency Ratios

Debt-to-equity ratio indicates the proportion of debt used to finance the company’s assets relative to shareholders’ equity. A high ratio suggests greater financial leverage and risk, while a lower ratio indicates a more conservative approach to financing. For construction companies, which often rely on substantial borrowing for project financing, monitoring this ratio is critical. Ratios higher than 2.0 can indicate that a company has taken on too much debt. Calculation: debt-to-equity ratio = total liabilities divided by equity.

Interest coverage ratio measures a company’s ability to pay interest on its debt with its earnings before interest and taxes (EBIT). A higher ratio indicates that the company comfortably covers its interest payments, reducing financial risk. For construction firms, which may have fluctuating income based on project timelines, this ratio helps assess debt sustainability. Calculation: interest coverage ratio = EBIT divided by interest expense.

Efficiency Ratios

Working capital turnover ratio reflects how efficiently a company uses its capital to support sales and company growth. The ratio provides a company with an understanding of revenue generated for every dollar of working capital used. A high ratio indicates that the company is efficient in using its assets and liabilities to support sales, with lower ratios indicating less efficiency. However, a ratio above 30.0 could signal that a company may need more working capital to continue to grow in the future. Calculation: working capital turnover ratio = total construction sales divided by working capital. (Working capital = current assets minus current liabilities.)

Equity turnover ratio, similar to working capital turnover ratio, reflects how efficiently a company uses its value — in this case, equity — to drive construction revenue. A ratio above 15.0 may signal that a company will have trouble growing in the future. Calculation: equity turnover ratio = revenue divided by equity.

Project-specific Ratios

Work-in-progress (WIP) ratio assesses the proportion of work completed relative to the total contract value. This ratio helps gauge project progress and can indicate potential issues with project execution or financial planning. Calculation: WIP ratio = work completed to date divided by total contract value.

Contract profitability ratio evaluates the profitability of individual contracts. This ratio provides insights into how well each project contributes to overall profitability, helping in assessing project management and pricing strategies. Calculation: contract profitability ratio = contract profit divided by contract revenue multiplied by 100.

Conclusion

Financial ratios are indispensable tools for understanding the financial health of construction companies. No single ratio will provide an overall picture for the health of a construction company. However, looking at several key financial ratios can help investors, shareholders, and management teams make informed decisions, identify potential risks, and implement strategies to enhance financial and operation stability, both now and in the future.

For construction companies, maintaining a balanced approach to managing these financial metrics is pivotal to sustaining long-term success in a competitive and often unpredictable industry.

Matthew Nash, CPA is a partner with Meyers Brothers Kalicka, P.C.