Can you pay all your bills? There is a measure you can use to determine how financially solid your company is at any given point in time. It's called the current ratio, or working capital ratio. It's a good idea to check your current ratio regularly, both to see how your business is faring, and to track changes over time.
Current ratio is the fancy term that money guys use to measure your bill paying ability. It measures the solvency of your business.
Your current ratio is your working capital divided by the bills you have to pay. For many businesses, the ideal ratio is 2. I like to think, because construction is a cost based business and a whole lot tougher to manage and make a dollar in than many other businesses, we need a little slack. So let's say that a construction company should have a ratio of 1.5 to 2. If you are at 1.5 you are doing okay. The closer to 2 you get, the better.
Your working capital is all the money you can put your hands on in a short period of time. That includes the money in your checking, savings, and operating capital reserve account. Include accounts receivable if you expect payment within a short period of time, and if you're confident the payments will be made. Don't include payments that are in dispute, or that you aren't confident about.
We're talking about business only, so don't include any personal funds. We're measuring the ability of your business to pay the business bills.
Now add up all your current liabilities. This would be all bills due and payable in the near future. This includes payroll, suppliers, subcontractors, utilities, vehicle or loan payments, etc.
Divide your available cash (working capital) by your bills (current liabilities) and that's your current ratio.
Working capital = $80,591
Current liabilities = $47,573
Current Ratio = $80,591 / $47,573 = 1.69
The company in this example is in good shape. You want to be at least 1.50. That gives you the capability of paying your bills without worry. You can meet payroll and stay current with your suppliers.
Here's another example:
Working capital = $31,405
Current liabilities = $27,385
Current Ratio = $31,405 / $27,385 = 1.15
With a ratio of 1.15, the company can pay the bills due, but it's close. If anything goes wrong on a job, or if a payment doesn't come in that you're counting on, you'll be in trouble. It's a dangerous position to be in.
One item that helps you keep your current ratio in a safe range is your operating capital reserve account. This, in fact, is the main reason you need to start and maintain an operating capital reserve account; it provides funds your business can use if and when money gets tight. We talk about the Operating Capital Reserve Account in the book Markup & Profit Revisited.
If your ratio is too low, or if you're seeing a trend where it's dropping over time, take action. It won't fix itself, and dreams or wishes won't help. The good news is that it's fixable. Run a few checks:
- Are you using the right markup, and are you using it consistently?
- Are you estimating jobs accurately?
- Do you have too many employees for your volume of business?
- Are you managing overhead expenses?
- Are you taking too much money out of the company for yourself?
If you answered yes to one or more of those questions, make changes. It's not easy, but as I said above, dreams and wishes won't fix it. You have to do it.
One last example, and this typifies many construction businesses:
Working capital = $12,210
Current liabilities = $19,638
Current Ratio = $12,210 / $19,638 = .62
This company doesn't have enough cash to pay its current bills. Unfortunately, too many contractors fall into this group. This leads to using the funds from future jobs to pay past bills, or borrowing from themselves to support the company. Both are dangerous habits, and if that's what's happening, things need to change soon.
Construction is cyclical, and I'm not just talking about the long cycles that tie to the economy. Your business will have good months and bad months every year. Too many bad months in a row will put your business in a precarious situation if you don't have the funds available to survive them.
If your business looks like the last example, run those checks on your business and get to work. Give me a call if you need more help.