Purpose of Financial Ratios and Key Performance Indicators (KPI)
The purpose of financial ratios and key performance indicators is to gauge the overall financial health of an service contracting organization and judge whether or not certain goals and objectives are being achieved.
They may provide warning signs of potential threats to a company’ solvency, gauge how efficiently an organization applies or utilizes assets, or even how well an organization collects their accounts receivable.
There are basically three types of financial ratios. They include solvency, profitability, and efficiency. Solvency ratios gauge how easily an organization can pay its bills. Profitability ratios judge how good a particular organization is at generating a profit. Efficiency ratios analyze such things as how well a company is able to utilize its working capital or other assets, as well as how quickly the company collects on their accounts receivable. Depending on your company’ own individual needs, you may also wish to develop certain other ratios that are not strictly financially related. These types of ratios may typically be classified as sales ratios, marketing ratios, and even investment ratios.
Financial managers should make a careful study of all financial reports, each and every month. These financial reports must include, in addition to an income statement and profit and loss statement, all relevant financial ratios to your particular industry, personal requirements, or your company’ unique needs.
We have briefly described each ratio below. We have attempted to cover its usage and meaning adequately. We have also attempted to give you an acceptable range to consider when evaluating or bench marking your own organization’ financial ratio data. These ranges should be considered only as rough guidelines for you to follow. Your company may have different needs than the industry as a whole.
Financial ratios are only as accurate as your least accurate financial numbers. These ratios may mean nothing if your company does not practice good quality bookkeeping that is timely and substantially accurate.
You must practice accrual type accounting for these ratios to be meaningful. As part of accrual accounting, your company must enter bills and other liabilities as your company encounters them. You must enter (record) revenue as your company encounters it.
See your accountant if you have any concerns regarding accrual accounting or the validity of these ratios.
Accounting Software Makes it Easier
Some enterprise level accounting software programs such as Total Office Manager® from Aptora® and Dynamics from Microsoft calculate financial ratios automatically. Specialized contractor software will show you industry averages and offer industry specific recommendations.
Return on Sales (AKA: Net Profit Margin) measures the before tax profits on the year’ sales. Our recommendation is 5% or greater.
(Net Profit Before Taxes / Net Sales) x 100
Return on Owner’ Equity (AKA: Return on Investment) measures the ability to realize an adequate return on the capital invested by the owners. Our recommendation is 25% or greater.
(Net Profit Before Taxes / Net Worth) x 100
Return on Assets matches net profits after taxes with the assets used to earn such profits. A high percentage rate can tell you the company is well managed and has a healthy return on assets. Our recommendation is 15% or greater.
(Net Profit After Taxes / Total Assets) x 100
Acid Test (AKA: Quick or Liquid Ratio) measures the extent to which a business can cover its current liabilities with those current assets readily convertible to cash. Our recommendation is 1.35 or greater. (Cash + Accounts Receivable) / Current Liabilities
Cash to Current Liabilities measures the company’ ability to handle an absolute worst case scenario where liabilities must be satisfied immediately. We generally recommend a ratio of 1. In other words, you have $1.00 in cash to pay off $1.00 of liabilities.
Cash / Current Liabilities
Sales to Total Assets measures the percentage of investment in assets that is required to generate the current annual sales level. If the percentage is abnormally high, it indicates that a business is not being aggressive enough in its sales efforts, or that its assets are not being fully utilized. A low ratio may indicate a business is selling more than can be safely covered by its assets. Our recommendation is generally 5 to 7.
Net Sales / Total Assets
Sales to Inventory (AKA: Inventory Turnover) typically applies to companies that rely on inventory to help create sales. When this ratio is high, it may indicate a situation where sales are being lost because a company is under-stocked and/or customers are buying elsewhere. If the ratio is too low, this may show that there is not a lot of demand for what you have in stock. Our recommendation is generally 6 to 8.
Annual Net Sales / Inventory
Collection Period (AKA: Average Age of Accounts Receivable) is helpful in analyzing the “collectability” of accounts receivable, or how fast a business can increase its cash supply. While each industry has its own average collection period, more than 10 to 15 days over terms should be of concern. Our recommendation is 40 or less.
(Accounts Receivable / Sales) x Days in Period
Sales to Total Labor Expense indicates how much of your total sales revenue is consumed by all payroll and labor related expenses. The lower the number the better, because it suggests that you are efficiently using employees to create and manage sales. Our recommendation is .3 or less.
Payroll / Sales
Sales to Technician (Field) Labor indicates how much of your total sales revenue (income) is consumed by payroll and labor expenses related to the field (usually sales, technicians and installers). The lower the number the better, because it suggests that you are efficiently using your employees to create sales. Our recommendation is .2 or less.
Field Labor COGS / Sales
Key Performance Indicators
This is the amount of hours that were paid but not billed to a job. A service department should bill out at least 40% of its total labor hours while construction should be 90% higher.
Average Amount Per Invoice
Obviously your goal depends largely on the type of work you are doing and the industry you are in. Be sure to set standards for your service and installation department.
Conversion Rate to Repair
This KPI indicates how many service calls (trip charges) were made versus how many of those trips resulted in an actual billable repair.
Conversion Rate to Service Agreement
Indicates how many service calls were made versus how many of those resulted in the sale of a service agreement. If you’re in the service business, you should have approximately 300 SAs per billable employee.
Net sales minus the cost of goods and services sold (direct expenses). Service work should yield a GP of 70% or higher while heavy construction can be 20%. One of your manager’ most important responsibilities is to protect profit margins on labor and materials.
A “callback” can be defined as return visit to correct an improper repair that cannot be billed. A good service department should have less than 2% of its service calls result in a callback.