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August 2018

Financial health check

17 Jul 2018, Insurance, Prove Your Know How

Whether you’re a fully-fledged business Jedi or fresh-faced padawan, it’s always worthwhile checking that you have a good handle on the numbers behind your business. These seven financial indicators will help you better understand your finances

One in two construction companies fall over within three years and 77% will have closed within a decade, according to Stats NZ’s 2017 New Zealand Business Demography Statistics.

These alarming figures are slightly above the base rate, which show that 46% of all businesses fail within three years and 73% fail with ten – this will be unsurprising to many who work within the building industry and understand the risks.

From our own experience, financial failure is one of the most common reasons for a building business to fail and we also know that it is a side of their business many builders struggle to properly manage.

Most claims under a Ten-Year Building Warranty happen because the building contractor has gone bust, leaving their customers in the lurch.

Financial failure is the most common reason a building company ends up in liquidation. That’s why it’s critically important that builders have a good handle on the key financial indicators of their business. The following seven measures will help you stay on top.

  1. Cashflow forecast

This is a monthly estimate of the cash owed to and by the business. It usually projects up to 12 months into the future.

This will show whether the business has enough money in the bank to pay its bills as they fall due. It also helps to show that while your bank balance may look healthy this week, that money is actually needed to pay bills next week.

  1. Gross margin

 This is measured in percentages and shows whether your work is correctly priced. It can also show if you’re earning enough from each project. If your gross margin is too low, raising your rates and cutting costs are steps you can take to bring it up. It should be at least 8%, and ideally it will be more.

Gross Margin = Gross Profit ($) / Total Sales ($) x 100

  1. Debtor days

This is measured, unsurprisingly, in days and shows how long it takes, on average, for your business to collect the money it is owed by customers.

The smaller the number, the better your company is at invoicing and receiving prompt payments. On the contrary, a high number can put pressure on your business’ finances by forcing you to borrow to cover costs.

Ideally for builders, this should be under 30 days. To minimise your debtor days, you could consider offering early-payment incentives or using an invoice factoring provider.

Debtor days (days) = # of outstanding accounts / total sales ($) x 365 (days)*

*Note that if you’re changing the period you want to measure, you’ll need to change the number of days accordingly. ie, for February use 28 days, or 29 in a leap year!

  1. Creditor days

This is basically a reverse of the debtor days calculation and is used to measure how long it takes you to pay your

creditors. It shouldn’t be more than 60 days. The higher this number, the longer it takes you to pay your bills, potentially indicating some trouble paying debts.

Creditor days (days) = # of unpaid bills / total purchases ($) x 365 (days)

  1. Current ratio or working capital ratio

This is a percentage figure that measures whether your business has enough liquid assets (stuff that can be turned into cash quickly) to pay its short term liabilities.

A healthy business should have more current assets1 than current liabilities2 and if the result is less than 100%, you should look at how you can reduce your liabilities as quickly as possible.

Current ratio (%) = current assets ($) / current liabilities ($) x 100

1This includes things such as your tools, work vehicles and any materials you have stored on site.

2This includes money you owe suppliers and contractors, and any debts you have.

  1. Equity ratio

This is a measure of how much of the business’ assets are financed by the owners and shareholders compared to debt (mortgages, loans etc).

The higher the percentage, the less a business is leveraged and the less of it is owned by banks and other lenders through debt.

Ideally, it should be 5% and lenders and insurers both like to see a small number as it helps determine how risky it is for them to work with a business. A business with a heavy debt load will be unattractive to lenders and can force people into riskier, high-interest finance options.

Equity ratio (%) = owner’s equity ($) / total assets ($) x 100

  1. Solvency ratio

A solvent business will have more assets than it does liabilities, indicating it can afford to pay back everything it owes. A solvency ratio less than 100% shows the business could be in trouble and may need an injection of capital from the owners.

Solvency ratio (%) = total assets ($) / total liabilities ($) x 100

Crunching numbers

A good accountant (particularly one that understands the construction industry and can properly account for work in progress) and accounting software are vital to the financial health of any building business, regardless of size.

They will help you understand the state of your current finances on a regular basis and, just as importantly, help to identify any potential future issues before they become critical. This will give you more control over your business’ financial health, reduce stress levels and make your business more attractive to banks, warranty providers and potential buyers.

Builtin are New Zealand’s trade insurance experts. For more information visit builtininsurance.co.nz or contact Ben Rickard at ben@builtin.co.nz or 0800 BUILTIN.

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