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Financial ratios are key parameters that help in understanding the financial health of a construction business clearly and effortlessly. They are a lifesaver when it is hard to determine the financial status of the company from a set of standard financial statements and documents.
Financial ratios give a quick and accurate indication of the company's performance in terms of liquidity, leverage, and financial efficiency.
This article discusses the major categories of financial ratios in a construction business.
Financial Ratios in Construction Business
Financial ratios are certain equations that help predict future outcomes and financial planning opportunities for the company's growth. These ratios are created based on the information provided on the company’s balance sheet and accounts.
All the major financial ratios come under four main categories, as mentioned in the table below:
| Sl.no | Financial Ratio | Definition |
| 1 | Liquidity Ratio | A liquidity ratio indicates the company’s ability to pay off short-term debts using the current assets. The two main ratios coming under liquidity ratios are:1. Current ratio2. Quick ratio |
| 2 | Profitability Ratios | Profitability ratios indicate the company’s ability to turn revenue into profit by utilizing its assets, equity, etc. The financial ratios in this category are:1. Gross profit2. Return on assets3. Return on equity |
| 3 | Leverage Ratios | Leverage ratios give information regarding how a company finances its assets and operations and the associated debts. It is also called the debt-to-equity ratio. |
| 4 | Efficiency Ratios | Efficiency ratios measure how well the company utilizes the generated assets and liabilities. The financial ratios in this category are:1. Equity turnover ratio2. Working capital turnover ratio |
The main financial key ratios that stand out are the current ratio, quick ratio, debt-to-equity ratio, working capital turnover ratio, and equity turnover ratio. Different companies employ different financial ratios based on the parameters that are studied.
No single ratio explains the overall performance of the business. Each ratio helps analyze a specific parameter. For example, a company's current ratio may be strong, but its debt-to-equity ratio can show too much debt. Comparing a specific ratio of one company with another is an excellent way to gauge the performance of the business.
5 Key Financial Ratios in Construction Business
Among the various categories and subcategories of financial ratios mentioned, the top 5 key financial ratios that a construction contractor must know are:
1. Current Ratio
Current ratio is a type of liquidity ratio that is calculated as the ratio of current assets to the current liabilities.
It is also called a working capital ratio.
Current Ratio = Current Assets/Current Liabilities
The current ratio indicates the company’s ability to pay off short-term debts using its assets. A good threshold value for the current ratio is >=1. This implies that the business has enough current assets to cover the cost of liabilities. A current ratio of less than 1 can indicate potential financial trouble. While a higher ratio is an indication of inefficient use of working capital.
2. Quick Ratio
Quick ratio is another type of liquidity ratio which is the ratio of current assets that include cash, cash equivalents, short-term investments, and accounts receivable (excludes inventories) to the total current liabilities.
Quick Ratio = (Cash + Accounts Receivable + Cash Equivalents)/Current Liabilities
Hence, the quick ratio measures the company’s ability to pay for current liabilities without converting assets into cash. It is also called the acid-test ratio. Financial analysts always look for a quick ratio between 1.1 and 1.5.
Quick ratio focuses on the easy assets that are quickly liquidated in case of emergency liability issues. Every item that takes time to liquidate is not included in this ratio.
3. Debt-to-Equity Ratio
This is a leverage ratio that measures how much growth the company has financed through debt. Hence, it is the ratio of total liabilities/debt to the equity on the company’s balance sheet.
Debt-To-Equity Ratio = Total Liabilities or Total Debt/Equity
A debt-to-equity ratio below 2 is considered a good value. But, a value greater than 2 indicates that the company has built too much debt to stimulate growth. This would hinder the company’s ability to obtain more loans.
4. Working Capital Turnover Ratio
Working capital turnover ratio measures how well the company utilizes its capital to support the sales and growth of the company. This ratio is considered both a liquidity and efficiency ratio.
Working Capital Turnover Ratio = Sales/Working Capital
Working Capital = Current Assets - Current Liabilities
A higher ratio indicates that the company is efficient in using its assets and liabilities for company sales. A lesser ratio indicates less efficiency of the company. When the ratio exceeds 30, it is tough to quantify, and hence it is used depending on the type of company.
5. Equity Turnover Ratio
It is an efficiency ratio that is calculated as the ratio of sales to equity. This ratio measures how efficiently a business uses its value to drive construction revenue.
Equity Turnover Ratio = Sales/Equity
Equity turnover ratio considers the use of equity rather than capital. For a construction company, a ratio greater than 15 could indicate future growth issues.
Financial ratios are a great tool for carrying out financial planning for a construction business. It helps to predict the future financial path of the company.
FAQs
Financial ratios give a quick and accurate indication of the company's performance in terms of liquidity, leverage, and financial efficiency.
Current ratio is a type of liquidity ratio that is calculated as the ratio of current assets to the current liabilities.
Current Ratio = Current Assets/Current Liabilities
Working capital turnover ratio measures how well the company utilizes its capital to support the sales and growth of the company.
Working Capital Turnover Ratio = Sales/Working Capital
Working Capital = Current Assets - Current Liabilities
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