|By Tracey Jeffers
Principal, Valuation Consulting
If you are involved with financial management at some level in your firm, you expect to regularly review the typical balance sheet and income statement. A smaller percentage of readers also are looking at a cash flow statement. A regular look at the balance sheet entails a quick glance overall, but those line items that change frequently— such as cash balances, accounts receivable, accounts payable, and fluctuations in debt— usually get the most attention. The income statement is focused on revenue generation, current costs, and profitability. The cash flow statement, of course, is a report on cash in and cash out. While these documents provide you with the vital information necessary to make good business decisions, I dare to say that they may not go far enough.
In the business of valuing privately held A/E/P and environmental consulting firms, we spend a good amount of time analyzing these statements for the story they tell. However, they are only part of the story. We also conduct an in-depth ratio analysis that allows for a deeper look into the financial drivers of the firm and measure that performance against others in the industry. As a principal and/or firm owner, you should be doing the same on a regular basis to gain a better understanding of how just a few internal operational tweaks can vastly improve performance and increase share value.
No matter how well-versed one may be with finance and financial terms, it never hurts to have a refresher. So, let’s take a look at a few key ratios that should be calculated and presented with your firm’s regular financial statements, along with median values from ZweigWhite’s 2011 Financial Performance Survey of Architecture, Engineering, Planning and Environmental Consulting Firms.
* Current ratio— current assets/current liabilities
The current ratio measures the ability of the firm to meet its short-term (less than one year) obligations. The current ratio measures those assets on the balance sheet that can be converted to cash, including accounts receivable, work in process and cash, and measures those assets against current liabilities. The greater the current ratio, the more solid financial position the firm has in terms of its liquidity. A ratio of 2.0 means that a firm has twice as many assets convertible to cash as it does liabilities. The overall 2011 median current ratio from the ZweigWhite survey is 2.26.
* Quick ratio— current assets(work in process)/current liabilities
This is another look at liquidity, although it is taken from a more immediate point of view by removing work in process, an asset that will take some time to convert to cash. The 2011 median quick ratio from the ZweigWhite survey is 2.04.
* Chargeability— (direct labor hours/total labor hours) x 100
Also known as the “utilization rate,” chargeability is a measure of the percentage of total raw staff labor hours charged to projects and it indicates the amount of a firm’s labor expenses that are billable. This measure includes all staff and is a good measure of efficiency and effectiveness. The 2011 ratio from the ZweigWhite survey is at a 10-year low of 52.8%.
* Breakeven multiplier – total payroll + total general & administrative overhead +1/direct labor
This multiplier calculates the amount a firm must generate per dollar of direct labor to cover its overhead costs and direct labor. The 2011 median multiplier from the ZweigWhite survey has increased to an eight-year high of 2.79.
* Break-even analysis— total fixed costs/gross margin
This is a simple way to help with your planning process to understand what the minimum level of sales you will need to make just to make it to zero net income at the end of the year. For example, if your annual fixed costs are $1,000,000 and gross margin is 35%, your firm will need to achieve total revenue of approximately $2.86 million. This is one of my favorite planning tools; it’s simple, yet powerful.
* Average collection period— accounts receivable/(gross revenue/365 days)
The average collection period measures the efficiency with which a firm collects revenue on completed projects. It is the number of days it takes from issuing an invoice to crediting payment against an account. The overall 2011 median ratio from the ZweigWhite survey is 77 days.
These ratios are but a few that can be calculated from your existing financial statements to provide you better information to determine if your performance metrics are headed in the right direction. In fact, there are nearly 100 indicators included in the 2011 Financial Performance Survey. Having a good understanding of performance metrics will enhance your ability to make good operational decisions and they provide you with the ability to measure the results of those decisions.
In today’s economic environment, firm owners need every tool possible to win. Don’t leave this type of analysis solely up to your banker, CPA, or specialists like myself. If you’re not already doing so, I encourage you to take charge and present some new material at the next board meeting. This simple but powerful information is just an Excel spreadsheet away.