In this installment of Accounting Basics for Small Contractors, we’ll look at specific KPIs (Key Performance Indicators) (aka benchmarks) that contractors should be monitoring.
In order to calculate and monitor KPIs, you first have to keep score! That’s not a gratuitous reference to my company’s name either. At a minimum, you should be receiving the basic financial statements (balance sheet, income statement and statement of cash flows) for your company on a monthly basis. With the advancements in technology and software, many contractors have access to these financial statements with the click of a mouse at any time, instantaneously. Many of these programs also produce numerous KPIs that you can review as needed.
Similar to comparing your golf score to other performances, you do the same thing with your company’s financial statements. How do this year’s sales totals compare to last year’s? To the budget? To other members of your association or group, if you’re involved in one of the best practices groups in our industry?
Let’s take a look at some of the basic KPIs that you should know and understand in order to make better business decisions. First, here are KPIs that come from the balance sheet.
Current ratio = Current assets divided by current liabilities
Current assets include cash and any other asset that can be turned into cash within one year of the date of the balance sheet. They include accounts like company bank accounts, accounts receivable, notes receivable, inventory and prepaid expenses.
Current liabilities include those obligations and accounts that are due or payable within one year of the date of the balance sheet. They include accounts like accounts payable, principal payments on loans due within one year, bank line of credit account, accrued expenses like payroll, payroll taxes and interest.
The current ratio shows how many dollars of current assets you have to pay the dollars of current liabilities due. The higher the ratio the stronger the company is financially. I’d like to see current ratios of 1.5 to 1 or higher. A current ratio of 1 to 1 or lower signals financial problems for the company.
The acid test, or quick, ratio is a more stringent current ratio. The equation is as follows:
Acid-test ratio = (Cash + investments + accounts receivable) divided by current liabilities
Again, the higher the ratio, the stronger the company is financially. A ratio of 1 to 1 or lower is especially disconcerting and indicative of financial problems.
Debt-to-equity ratio = Total liabilities divided by total owners or stockholders’ equity
The debt-to-equity ratio calculates the proportion of the company’s assets supplied by the creditors versus the amount supplied by the owners. The higher the ratio here, the more the company is leveraged, i.e., the more the company is financed by creditors. So a ratio of 2 to 1 or 1.5 to 1 signals financial problems for the company as compared to a ratio of 1 to 1.
Accounts receivable turnover is the number of times per period that the accounts receivables turn over. This is an average figure because both sales and accounts receivable fluctuate throughout the year. The formula is as follows:
Accounts receivable turnover = Net credit sales for the period (month, quarter, year) divided by the average accounts receivable for the period. NOTE: The average is derived by adding the beginning and ending accounts receivable balances together and dividing by two.
Average collection period can be determined by dividing 365 by the accounts receivable turnover figure. For example, if the accounts receivable turns over 10 times during the year, the average number of days to collect accounts receivable will be 36.5 days.
Inventory turnover is the number of times per period that the inventory turns over. Again, this is an average figure because both sales and inventory fluctuate throughout the year. The formula is as follows:
Inventory turnover = Cost of goods sold for the period (month, quarter, year) divided by the average inventory for the period. NOTE: The average is derived by adding the beginning and ending inventory balances together and dividing by two.
Average number of days to sell inventory can be determined by dividing 365 by the inventory turnover figure. For example, if the inventory turns over 10 times during the year, the average number of days to sell inventory would be 36.5 days.
Accounts Payable turnover is the number of times per period that the accounts payable turns over. This is an average figure because both cost of goods sold and accounts payable fluctuate throughout the year. The formula is as follows:
Accounts Payable turnover = Cost of goods sold for the period (month, quarter, year) divided by the average accounts payable for the period. NOTE: The average is derived by adding beginning and ending accounts payable balances together and dividing by two.
Average payment period can be determined by dividing 365 by the Accounts Payable turnover figure. For example, if the accounts payable turns over 10 times during the year, the average payment period would be 36.5 days.
Michael Bohinc is a Certified Public Accountant in Cleveland, Ohio, and the owner of Keeping Score Inc. He has served as the Chief Financial Officer of Norhio Plumbing Inc., his family’s plumbing company in Aurora, Ohio, since 1988. A veteran speaker, he's trained hundreds of contractors in the basics of accounting and on fraud prevention. He also currently serves as the Interim Director for the Service Nation Alliance – Plumbing Group. He's also a die-hard Cleveland Indians fan. You may contact him via e-mail at [email protected].