Last month, we introduced the NECA Financial Performance Report (FPR) and began reviewing the data within it. Let’s continue with some additional measures of profitability.
Return on assets (profit before or after tax ÷ total assets) and return on net worth (profit before or after tax ÷ net worth) also measure profitability. The first indicates how efficiently management uses assets to make money, and the second shows the return on the owner’s investment. Return on assets (using profit before tax) is highest for the largest firms with $10 million to $20 million in annual sales volume, at 14.25 percent, and lowest (at 3.76 percent) for the smallest firms (under $2 million). This replicates the pattern for the profit on sales ratio. High-profit firms show a 21.40 percent return, more than double the 10.22 percent for all firms.
Return on net worth targets should be 20 to 30 percent before tax, since electrical contracting is a high-risk business. Both the impressive 46.35 percent for high-profit firms and the 26.17 percent for all firms meet those targets. Both ratios show a substantial improvement over the 2004 results and indicate that owners are earning a proper return on their investment. Again, by volume, the best return (35.22 percent) is earned in the $10 million to $20 million category, with the poorest return earned by the smallest (13.74 percent) and largest (19.41 percent) companies.
Another key category measured in the FPR is financial structure or leverage. Leverage means doing more with less, and one key measurement is the debt-to-equity ratio (total liabilities ÷ equity). The closer this ratio is to 1 ($1 in equity for every $1 in liabilities), the easier it is to borrow money, since the owners still own more of the company than the lenders. Ratios as high as 2.5 still are acceptable, but the 1.12 for high-profit firms, and 1.56 for all firms reporting, are far more conservative.
The smallest firms show the highest ratio (2.65) by volume, and the lowest (1.27) for those in the $10 million to $20 million category. Firms over $20 million show higher burdens, at 1.61 for the $20 million to $30 million range, and 1.59 for the largest firms (more than $30 million in volume). Again, the correspondence with sales volume holds true.
The banking industry views lending to contractors as an “exception,” so a conservative debt-to-equity ratio is imperative if you’re going to grow the company, since debt is the principle way to fund growth. Your growth rate (net profit after tax – dividends ÷ net worth) should not exceed 10 percent of sales volume. The reported growth rates of 14.22 percent for all firms and 24.38 per-cent for high-profit firms will challenge company cash flow and add to debt burdens, since revenue and profits lag well behind the required cash outlays.
Lending is increasingly based on cash flow (liquidity) rather than assets (collateral), which makes the relationship between accounts receivable (AR) and accounts payable (AP) significant. The FPR provides two comparisons of AR and AP. The first is the ratio of AR ÷ AP, which should fall between 2 and 3. All firms show a ratio of 3.22, with high-profit firms at 3.55. While both are high, the relationship to sales volume has improved, with the largest firms (more than $30 million) at 2.75 in spite of an 85-day collection period, nearly 20 days higher than other volume categories. The smallest firms had the shortest collection cycles (less than 60 days).
The second measurement subtracts average payable days from average receivable days, and the acceptable range is 30 to 45 days. The average collection cycle for all firms is 66 days, with high-profit firms showing a four-day advantage. The cycle increases directly with sales, from about 30 days for the smallest volume companies to nearly 56 days for the largest. Growth often increases financing of customer jobs, while collection procedures become lax. The receivables minus payables figures decreased by 10 to 20 days across the volume range, compared to the 2004 report. This could result from collecting receivables sooner, holding payables longer or a combination of both.
Actually, it seems to be a combination, since the payables cycles have increased by about five to seven days from the two-and-a-half weeks shown on the last report. Not surprisingly, the $10 million to $20 million-volume companies pay fastest (18.41 days), and the largest companies are the slowest at just under 30 days. That’s fine if these companies are receiving discounts for early payment, but it puts the measure of AR – AP in average days near the upper end of the acceptable range. Electrical con-tractors pay their bills on time but are still financing customer receivables. Staying within a 30- to 45-day range requires a balance between financing jobs and timely payment to your vendors.
These are just of few of the things you’ll find useful in the FPR. Now that you know what a valuable tool it can be, get a copy, use it and plan to participate in the next data collection survey. Information is power, and knowing where you stand can make the difference between surviving and thriving in any economy. EC
NORBERG-JOHNSON is a former subcontractor and past president of two national construction associations. She may be reached at email@example.com.