Financial Ratios That Matter

By Mike Vorster, Contributing Editor | September 28, 2010
Mike Vorster, Virginia Tech

Mike Vorster

David H. Burrows Professor of Construction Engineering and Management at Virginia Tech.

A balance sheet is one of two standardized financial reports produced on a regular basis. It provides information used by professionals in the financial community to analyze company performance and see how the company uses its available financial resources. Equipment plays an important part in the company's financial structure, so equipment managers must understand how their decisions affect the balance sheet. Various financial ratios measure performance in areas such as liquidity, profitability, leverage and financial efficiency.

Although financial jargon encompasses these ratios, it is more straightforward than it appears. We covered the basic concepts, the language used, and the way equipment-related transactions impact the balance sheet in February 2005. We'll recap that discussion and then work through an example that shows how a number of standard and well-understood ratios are calculated and used.

A balance sheet is a concise document that provides a snapshot of the capital structure of the company at a certain point in time. The left side lists the assets the company owns and uses in its business. These are listed in order of the speed with which they can be liquidated or turned into cash. Cash, receivables and the like are listed at the top; noncurrent or long-term assets are listed at the bottom. Of particular interest are the fixed assets or the property, plant and equipment owned, listed and included on the balance sheet. These are given at their original purchase price less the depreciation accumulated to date on the listed assets. If property, plant and equipment is mostly the equipment fleet, then the net value quoted in the balance sheet is equal to the accounting book value of the fleet.

The right side of the balance sheet lists liabilities and net worth. Liabilities (what the company owes others) are listed in order of their immediacy. Short-term liabilities such as payables are at the top; long-term liabilities such as loans and debt are at the bottom. Net worth or owners equity is also on the left side. This lists the original investment and paid-in capital as well as the retained earnings that have been accumulated as a result of successful operations. Our net worth is the difference between what the company owns and what it owes others; thus the left side of the balance sheet (assets) must equal the right side (the sum of liabilities and net worth).

The accompanying table shows an abbreviated balance sheet for our example company. The numbers are close to the values quoted by the Construction Financial Management Association (CFMA) for a large, best-in-class heavy/highway contractor. To complete the analysis, we need to know the contract revenue and net earnings before tax, found in the annual statement of earnings. Using CFMA numbers of $171,000,000 and $6,300,000, respectively, for the same class of business, the analysis should indicate values expected from a well-run business.

Any number of ratios can be calculated based on the data given in a balance sheet and statement of earnings. Some are exotic and are used for special purposes; others have stood the test of time and are in common usage. Good practice categorizes the well-used ratios into four performance areas: liquidity, profitability, leverage and efficiency. Let's look at two commonly used ratios for each area and then propose two additional measures of particular interest to equipment specialists.

Liquidity: Both measures indicate the degree to which the company can meet its immediate short-term commitments (current liabilities) using current liquid assets. A current ratio of 1.0 indicates that current assets at least equal current liabilities. These measures are important from an equipment point of view because purchasing a machine with cash reduces current assets and severely strains both working capital and the current ratio.

Profitability: Return on assets evaluates profitability relative to the sum of all the assets used. Return on equity measures profitability relative to what the owners have at stake in the business. The ratios behave differently from an equipment point of view. Increasing the size of the fleet, especially using debt, increases total assets and makes it difficult to achieve a good return on as-sets. It does not affect return on equity, though.

Leverage: Debt to equity indicates the relationship between the creditors who provide the debt that makes up current or long-term liabilities and the owners who own the total net worth. CFMA reports that a value of 3 or lower is considered acceptable. In many cases, this limits the amount that can be borrowed to finance equipment. The fixed asset ratio measures how much of the owner's equity is invested in the book value of the equipment. This is clearly an important ratio from an equipment point of view. All classes of heavy and highway companies reported by CFMA show values well in excess of 50 percent with some categories of medium-sized companies showing values close to 70 percent. Not surprisingly, industrial contractors show ratios in the low 20-percent range.

Efficiency: These measure the efficiency with which assets are used to generate contract revenue. Both are important from an equipment point of view as equipment is a key player in generating the numerator —contract revenue — as well as a large component of the denominators — total assets and net fixed assets.

Equipment-Specific: The equipment-to-assets ratio measures the size of the fleet as a percentage of the total assets used by the company. Heavily equipment-intensive operations have high numbers that are frequently brought down by leases or outside rentals. The book value ratio is a good measure for the average age of the fleet. In this case, all but 41 percent of the purchase price of the fleet has been written off, indicating that the average age of the fleet is close to 60 percent of the period used to calculate the accounting depreciation. A low value is a strong indicator that the fleet is becoming old and not being replaced at the required rate.

Information contained in the balance sheet can be used to measure performance in a number of ways. Because equipment plays an important part in each case, equipment managers absolutely must understand what is involved and do their part in achieving the desired results.

Abbreviated Balance Sheet
This sample balance sheet uses values quoted by Construction Financial Management Association for a large highway/heavy construction firm.
Assets: What we own     Liabilities: What we owe others  
Current assets   $52,000 Current liabilities $35,500
Property, plant and equipment     Noncurrent liabilities $9,100
At purchase price $42,100   Total liabilities $44,600
Less depreciation -$24,800   Net worth: What we are worth  
Net   $17,300 Stock and paid in capital $6,500
Long-term investments   $800 Retained earnings $23,100
Other noncurrent assets   $4,100 Total net worth $29,600
Total assets   $74,200 Total liabilities & net worth $74,200

Key Ratios
Ratio Definition Example Value
Key ratios indicate commonly tracked financial performance measures, and equipment-specific ratios help managers make decisions.
Working Capital Current Assets - Current Liabilities $52,000 - $35,500 $16,500
Current Ratio Current Assets ÷ Current Liabilities $52,500 ÷ $35,500 1.46
Return on Assets Net Earnings ÷ Total Assets $6,300 ÷ $74,200 8.5%
Return on Equity Net Earnings ÷ Total Net Worth $6,300 ÷ $29,600 21.3%
Debt to Equity Total Liabilities ÷ Total Net Worth $44,600 ÷ $29,600 1.51
Fixed Asset Ratio Net Fixed Assets ÷ Total Net Worth $17,300 ÷ $29,600 58.5%
Asset Turnover Contract Revenue ÷ Total Assets $171,000 ÷ $74,200 2.3
Fixed Asset Turnover Contract Revenue ÷ Net Fixed Assets $171,000 ÷ $17,300 9.8
Equipment to Assets Net Fixed Assets ÷ Total Assets $17,300 ÷ $74,200 23%
Book Value Ratio Net fixed assets ÷ Purchase price $17,300 ÷ $42,100 41%