The Construction industry may find itself already halfway through the third quarter of the year, but data flowing out of the second quarter may hold the key to a successful second half of the year. Two key dates from the second quarter were April 30 and May 31. Why are those significant? For most construction companies these are the dates their CPA-prepared 2022 financial statements (preferably prepared in accordance with GAAP) were due.
This leads us to the bigger question: How did certain key performance indicators (“KPI”) shape up for 2022 and how did these change as compared to 2021? Let’s look at three categories of KPIs that are critical to the construction industry.
Profitability is the category of KPIs that measures a contractor’s operating results, gross or net, against another financial component to see how effective, profitable if you will, the business truly is. While net profit/income is relative to its total expenses, gross profit measures how much money a contractor is making (or losing) on the actual construction projects, individually and in totality. Four ratios that are commonly analyzed in the construction industry are:
- Return on Assets – net income generated by the total assets employed.
- Return on Equity – net income generated by the net assets employed can also be viewed as the owner’s return on their investment. Please note that direct equity transactions, such as distributions, would be considered in this KPI as well.
- Gross Profit – one of the more important percentage ratios, as noted above, tells us how well a contractor is performing on a (or all) project(s) in process and completed in a period.
- Net Income – the bottom line, quite literally as the last line in the statement of operations, this is the final operating financial result against construction revenues for the year.
Our expectation coming into 2023 was that most of these ratios were going to suffer a decline as compared to the prior year. This was based on the conditions most contractors enjoyed in the recent past, which were one-offs such as Paycheck Protection Program (“PPP”) forgiveness and Employee Retention Credit (“ERC”) income that positively impacted results. Plus, according to numerous industry executives and leaders, there were countless projects taken at lower-than-expected margin levels (not the time to speculate why in this article) that were bleeding into the period.
Profitability KPI Study Results
|Return on Equity
|Return on Assets
* This ratio varies greatly amongst industries and locations, as well as industry segments.
With the exception of return on equity, the KPIs did decline but within 2%, making the changes almost negligible. While it is clear (and common sense) that there is an impact from PPP and ERC income falling off for 2022, one has to wonder when we are going to see the impact of aggressively bid work coupled with inflation.
Liquidity KPIs measure the ease with which a contractor’s assets can be converted into cash without affecting its market price. In other words, it is the ability of the contractor to meet their short-term financial obligations as they come due.
A simple scenario to calibrate our brains before we look into the ratios: consider a contractor who is carrying an under-billing on a project; we would want to understand what is driving it and if the construction company has the ability to realize the cash value. If the under-billing is based on timing, costs were incurred before approved billings, one could take the position it is liquid. But take the same under-billing and pin it to pending change orders, and the liquidity KPI could be impacted.
- Current ratio – One of the more important ratios to the construction contractor as it helps determine credit capacity. At its face, it assesses the availability of current assets to satisfy current liabilities.
- Quick ratio – This ratio gets a touch more granular as it assesses how the availability of readily liquid assets (cash, securities, receivables) can satisfy current liabilities.
- Working capital turnover – Measures how efficiently the contractor is utilizing their working capital to support the projects. While a bit more detailed, this can be measured at the project level as well as for the contractor overall. A high turnover ratio would demonstrate that the contractor is being very efficient in using their current assets to satisfy current liabilities to support contracts in process. Going back to the scenario above, we would advise using this KPI to understand what is driving under and over-billings.
The expectation within the liquidity KPIs would be a decline across all three ratios. One could argue that because PPP debt fell off from the contractor’s liabilities, coupled with collected ERC funds, the ratios should increase (but please keep in mind that most of those ERC checks were spent before they cleared). Not to mention there was a new accounting standard that privately held contractors had to adopt for 2022, ASC 842 Leases. This guidance saw companies record their leases on the balance sheet as another asset with a corresponding current and long-term liability. Process that for a second. Contractors had to record a current lease liability with no offsetting current assets. Logically, that alone would bring the liquidity KPIs down.
Liquidity KPI Study Results
|Working Capital Turnover
Our expectation was met, sort of, with two of the three ratios declining year over year. The current ratio does contain contract assets; under-billings, retainage, and capitalized mobilization costs, which were higher than in the past. Looking at certain market conditions, the increase in this asset class makes sense; it is taking longer for contractors to get paid, some value of change orders is being recognized while the contractor waits for approval, and costs have been incurred, but projects are delayed. So, while somewhat artificial, the increase makes sense.
By its definition, the quick ratio is a better indicator of the contractor’s liquidity, removing contract assets (and liabilities) from the equation. And as expected, it declined. Three words: cash is king. While contractors enjoyed all-time high cash balances in 2020, those reserves have been depleted as a result of high material and labor costs and more lag time between requisition funding, assuming projects are not delayed. This means contractors have to seek outside capital/debt and with high interest rates; being short on cash can be expensive for the construction industry.
And as we look at the decline in the working capital turnover, it seems to be driven by a decline in revenues. It has been well documented across the industry that contractors’ backlogs were being burned off faster than replacement work was signed through 2020 and 2021, resulting in lower revenues in 2022. With working capital balances remaining somewhat stable (the increase in the current ratio supports this), the turnover declined.
Leverage KPIs will help the contractor assess how effectively they are using debt or borrowed capital within operations to create revenues and eventually equity. The construction industry does have its own subsect of leverage KPIs which we looked at as well.
- Debt to Equity – An important ratio, this measures the degree to which a contractor is financing its operations with debt rather than its own resources. Put another way, it indicates the relationship of creditors to owners.
- Under-billings to Equity – While each under-billing has its own facts and circumstances, they generally represent costs incurred that have yet to be billed for. When looking at under-billings as compared to equity, it tells the contractor the level of unbilled contract volume being financed by ownership.
- Backlog to Equity – Indicates the relationship of committed work to owners’ equity. This ratio helps the contractor and users of their financial reports conclude if there are enough net assets in the company to meet committed work/future revenue obligations.
- Revenue to Equity – Indicates the level of revenue being supported by each $1 of equity. This is an important ratio to look at as we know new work is slow to be awarded and/or commence while costs still remain the same or higher than a year ago.
As for the leverage KPIs, our expectation was that these would increase for 2022. If we simply go back and read through the market conditions previously discussed in this article, revenues slowing down, expenses increasing, cash balance dwindling, and cost of capital increasing, it stands to reason as contractors utilize debt they will become more leveraged.
Leverage KPI Study Results
|Debt to Equity
|Under-billings to Equity
|Backlog to Equity
|Revenue to Equity
As one can see, our expectations were met as the leverage ratios, except for the revenue to equity, all increased. While we won’t opine on all of the changes, we did ask ourselves, did contractors take on more debt in 2022 than in the past? In some instances, we did see lines of credit either remain stable or increase, so yes. But also keep in mind ASC 842 Leases, under which contractors had to recognize a lease liability, which was not considered in 2021’s ratio.
Under-billings were certainly on the rise in 2022 – a function of timing (how many times did we experience an increased wait time in processing and payment of requisitions during the year?) and pending change orders. This is a scary increase, as it is now above the industry-accepted benchmark, and we are seeing contractors dig deeper into their pockets to put work in place.
Interestingly enough, the one KPI that did not experience an increase was revenues to equity. We know replacement revenue is coming in slowly, which this demonstrates. But this also shows that the industry is taking steps to conserve equity to compensate for the slower bidding, awarding, and commencement process for upcoming construction projects.
KPIs are a great tool the savvy contractor can utilize to identify areas where there may be challenges but also where they are excelling. While we did not explore all ratios across all categories, what was presented is a great place to start your benchmarking journey to help create new insights and financial access points into operations.
Whether you are trying to be in line with the best of the best, positioning yourself for a sale (EBITDA optimization), or just ready to get your financial forecasting in order, KPIs are a great way to build culture across the organization, getting project teams, accounting, and upper management to collaborate, be accountable and focus on common goals.
For more information on Grassi’s benchmarking reports, assistance with EBITDA optimization, and other KPI-driven strategies, please contact Carl Oliveri, Construction Practice Leader, at 212.223.5047 or email@example.com.