Although most contractors start their company because they love building, running a successful business requires more skills than construction alone.
The financial stability of your business plays a large role in long-term success, and it’s important to understand what all the numbers in your finances mean.
Balance sheets. Profit and loss statements. Income statements. There’s a lot to unpack in these financial documents. This is where financial ratios come in. Financial ratios are equations you can use to sort through your finances and see how well your business is performing. Here’s a rundown of the 3 main ratios construction businesses can use to determine profitability and success.
Liquidity Ratios
Liquidity ratios are a way to determine how quickly your construction business will be able to pay off debts. And we’re not talking about paying off one loan by taking out another loan. Liquidity refers to paying off debt with assets that are readily available, like cash in a bank account. These ratios will help you determine the health of your company in the event that all of your short-term debts came due immediately. Would you be able to pay them off? Or would an event like that put you under? There are a couple of liquidity ratios you can use to help figure that out:
- Working Capital/Current Ratio – Current assets divided by current liabilities will provide this ratio. The number you’re shooting for here is about 1.0, though up to 1.3 or even a little higher is also great. If your number is below 1.0, this could indicate financial trouble down the road [Lane Gorman Trubitt].
- Quick Ratio – Divide your cash on hand plus accounts receivable by current liabilities to get a quick ratio. A ratio between 1.1 and 1.5 is ideal here. This is similar to a current ratio, but only takes into account assets that are quickly convertible to cash, unlike inventory and supplies that may take some time to sell.
Leverage Ratios
This ratio takes a look at how heavily your company is leveraged. Businesses require a mixture of investments and debt to operate successfully, but you should be wary of leaning too heavily on debt. This leverage ratio examines the relationship between the two and encourages a healthy balance.
- Debt-to-Equity Ratio – This ratio takes a look at how much of your company’s growth has been attained through debt. To find this ratio, divide your company’s total liability by the equity found on your balance sheet. You want to keep this ratio under 2.0. A number higher than this indicates that your business relies too heavily on debt.
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