Financial ratios play a crucial role in providing a clear and straightforward insight into the financial well-being of a construction business. When traditional financial statements and documents leave you scratching your head, financial ratios step in as a helpful guide.
Financial ratios, essentially equations derived from a company’s balance sheet and accounts, serve as predictors for future outcomes and growth opportunities. These ratios fall into four primary categories, each shedding light on specific aspects of the company’s financial landscape.
Liquidity ratios assess a company’s ability to settle short-term debts using its current assets. There are two key ratios under this category:
Current Ratio
Current Ratio=Current AssetsCurrent LiabilitiesCurrent Ratio=Current LiabilitiesCurrent Assets
This ratio gauges the company’s capacity to cover short-term obligations. A current ratio of 1 or more indicates financial health, while less than 1 suggests potential financial challenges.
Quick Ratio
Quick Ratio=(Cash+Accounts Receivable+Cash Equivalents)Current LiabilitiesQuick Ratio=Current Liabilities(Cash+Accounts Receivable+Cash Equivalents)
Also known as the acid-test ratio, the quick ratio focuses on easily liquidated assets. Financial analysts target a ratio between 1.1 and 1.5.
These ratios reveal how effectively a company turns revenue into profit. The key ratios include:
Gross Profit
Gross Profit Ratio=Gross ProfitRevenueGross Profit Ratio=RevenueGross Profit
Profitability ratios also encompass Return on Assets (ROA) and Return on Equity (ROE).
Leverage ratios unveil insights into how a company funds its operations and assets, particularly its debt-to-equity ratio.
Debt-To-Equity Ratio
Debt−To−Equity Ratio=Total LiabilitiesEquityDebt−To−Equity Ratio=EquityTotal Liabilities
A ratio below 2 is favorable, signaling healthy growth financing.
Efficiency ratios measure how effectively a company deploys its assets and liabilities. The key ratios are:
Working Capital Turnover Ratio
Working Capital Turnover Ratio=SalesWorking CapitalWorking Capital Turnover Ratio=Working CapitalSales
Efficiency is indicated by a higher ratio, while a lower ratio suggests inefficiency.
Equity Turnover Ratio
Equity Turnover Ratio=SalesEquityEquity Turnover Ratio=EquitySales
This ratio assesses how efficiently a business utilizes its equity for construction revenue. Ratios exceeding 15 may hint at potential growth challenges.
While no single ratio provides a comprehensive overview of a business’s performance, collectively, they offer a nuanced understanding. Comparing ratios between companies enables a more insightful evaluation. In the construction industry, these financial ratios serve as valuable tools for effective financial planning and forecasting.
