Trends in contractor ratios: laying a foundation for financial analysis

RMA Journal, The, March, 2005 by Dev Strischek

A contractor operates within a difficult environment: the business cycle's inevitable expansion and contraction, construction activity's innate volatility, and the industry's intense competition. Here are the nuts n' bolts of financial analysis for contractors from RMA's professor emeritus of construction lending. Dev Strischek's blueprint for analysis uses RMA's Annual Statement Studies, which has served credit professionals for the past 85 years.

The British playwright George Bernard Shaw concluded that his observations over time merely confirmed his hunches: "The longer I live, the more I see that I am never wrong about anything, and that all the pains I have so humbly taken to verify my notions have only wasted my time." A similar notion may run through readers' minds as they review this article's charts and tables of ratios tracking the ebbs and flows of contractor financial fortunes. The economic life of a contractor is as changeable and challenging as any project, and the graphs scale the heights and plumb the depths of this vicissitudinous industry.

The ratios charted in this article rely heavily on RMA's Annual Statement Studies. The summaries that appear in Figures 1 through 6--profitability, efficiency, liquidity, leverage, debt composition, and solvency ratios--are drawn from simple averages of the various contractor lines over the years 1980-2001 as shown at the end of this article in Figure 7 (1).

[FIGURES 1-6 OMITTED]

All inferences from statistics are inherently tempered by uncertainty, and the risk is all the greater with any numbers submitted by volunteers and tabulated by a trade association. Further, the sample tends to be drawn from contractors who are bank customers, a distinction that is likely to draw more heavily from creditworthy contractors than from the less creditworthy. Finally, the population itself from which the sample is drawn changes over time, so the sample's variation from year to year may dampen the reader's willingness to rely totally on the validity of observations offered in this article. Nevertheless, the stability of the ratios, the large sizes of the samples, RMA's quality standards in conducting its annual survey, and the constancy of the Annual Statement Studies have all contributed to an admirable consistency over time.

Trendy Observations

So what can we learn from over 20 years of ratio trend analysis? First, the ratios tend to improve with the economic expansion, and they tend to deteriorate during contraction. The profitability ratios bear out this generalization as a quick glance at the early 1980s and early 1990s (see Figure 7 at the end of this article) will show.

Second, the rebounds from the recessionary lows do not seem to restore the previous period's highs. The liquidity ratios look to be almost as good in the mid-1990s as they were in the 1980s, but not quite. Maybe borrowers are getting better at managing financially with less; perhaps lenders are becoming more tolerant of narrower profit margins, lower working capital positions, and thinner equity cushions.

Finally, the ratios offer a few benchmarks and standards that have held over the 20-year period. For example, the average gross profit margin has run consistently in the low 20% range. Days receivables hang steady at 53 to 54 days and days payable around 30 days. The debt-to-worth ratio held steady between 1.6 and 1.8 year after year until the early 1990s, when it began its steady rise to over 2.0 by 2001.

Likewise, net worth averaged 40-43% perennially until the early 1990s, when it began its decline in lockstep with the debt-to-worth ratio to 33% by 2001. Interest coverage has maintained a 3.0 ratio over the years. Despite the turmoil of recessions and the longest economic expansion in recent history, the ratios do reflect a stability that circumstances would not warrant.

Ratio Groups

Each of the four financial analysis groups is comprised of representative ratios taken from RMA's Annual Statement Studies and arrayed year by year to depict trends within these groups. Most of the ratios are well known to bankers and financial analysts, and the Statement Studies provides definitions of the ratios in the introduction to each annual edition. For the purposes of this article, the following outline discloses the component ratios of each group with an arithmetic description of their quantitative components and their display as a percentage (%) or as a ratio (X) in Figure 7's Ratio Trends for Contractors:

1. Profitability

a. GP/Sales (Gross Profit/Sales), expressed as %.

b. GP/PBT (Gross Profit/Profit Before Taxes), expressed as X.

c. PBT/Sales (Profit Before Taxes/Sales), expressed as %.

d. PBT/TNW (Profit Before Taxes/Tangible Net Worth), expressed as %.

e. PBT/TA (Profit Before Taxes/Total Assets), expressed as %.

2. Liquidity

a. Current Ratio, expressed as %.

b. Days Receivable Outstanding, expressed in days.

c. Days Payable Outstanding, expressed in days.

d. Sales/NWC (Net Working Capital), expressed as X.

d. NFA/NW (Net Fixed Assets/Net Worth), expressed as X.