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Key Ratios

Dear Dave
In your opinion, what are some of the more important financial ratios and indicators to keep an eye on? Please tell us how to find each ratio and indicator, and what are some engineering firm benchmarks to compare our own statistics/performance to.

Dear SS
Your firm’s basic financial reporting package should include two primary reports: An Income Statement (Profit and Loss Report) and a Balance Sheet. The income statement measures income relative to expenses for the period of time covered by that particular statement. The balance sheet examines the relative relationship between the firm’s accumulated assets, and its liabilities, and its owner’s equity as of the date of the balance sheet.

Let’s begin with three key ratios from the income statement: the direct labor utilization rate, the breakeven overhead rate and the effective multiplier. It would be my suggestion that all firms track and monitor these three ratios on a monthly and year-to-date basis to understand how financially effective they are at operating their firms.

The direct labor utilization rate is payroll charged to job numbers divided by total payroll. The industry average direct labor utilization rate is around 65%. The remaining 35% of payroll (indirect labor) is spent for paid benefit time-off, administration, marketing, training and all other activities not directly identified with any particular client project. Since payroll is by far the single largest cost to operate a firm, generally speaking, the higher the direct labor rate, the more efficiently managed economically is the firm.

This brings us to the breakeven overhead rate. Breakeven overhead is total indirect expenses divided by direct labor. Indirect expenses include indirect labor along with all other general and administrative expenses such as payroll taxes, benefits, heat, light, rent, etc. incurred to operate the firm, but before any discretionary expenses such as bonuses, elective profit sharing contributions and incomes taxes at the business level. The current average breakeven overhead rate for the industry is approximately 135% of direct labor. For every dollar of direct payroll firms spend on projects, firms on average incur an additional $1.35 of indirect expenses (overhead). The current industry rate of 135% represents a decrease from previous years. The primary reason for this decline is the fact that direct labor rates at firms have been increasing in recent years due to high workloads and tight schedules. Since direct labor is the denominator of the overhead formula, as direct labor rises (reducing indirect labor and shrinking the numerator) you would naturally expect to see breakeven overhead rates fall as a result.

Our last income statement ratio is the effective multiplier. The effective multiplier is net fee income divided by direct labor. Net fee income is total income less all direct project expenses other than payroll. Stated another way, net fee income is the portion of gross fees billed that you get to keep for your effort on projects after subtracting out costs of consultants and other project specific expenses incurred to complete projects. According to the latest survey information, the average effective multiplier achieved is about 2.90. For every dollar of direct labor spent on projects, firms generate about $2.90 of net fee income. In essence, the effective multiplier measures the firm’s efficiency at converting direct labor spent completing projects into revenue dollars.

Turning our attention to which key balance sheet ratios and indicators to watch, I would recommend that firms begin by tracking and monitoring their debt to worth ratio and current ratio.

The formula for the structure of the balance sheet is total assets minus total liabilities equals owners’ equity (sometimes also referred to as the net worth or book value of the firm). Assets are grouped into current assets and long-term assets. Current assets are those assets that are either cash or those that are expected to naturally convert to cash within a period of 12 months. In addition to cash itself, the single largest current asset for most firms is accounts receivable (outstanding invoices sent out, but not yet paid by clients). Long-term assets are items such as real estate, vehicles, computers, equipment, office furniture, software, etc. Like assets, liabilities are also characterized and grouped as either current or long-term, depending on whether the debt or obligation is due and payable within 12 months or beyond twelve months.

Debt to worth is total liabilities divided by owners’ equity. If your firm has ever borrowed any substantial amount of money from a bank, chances are you are already familiar with this particular ratio as it is one of the primary measures of firm health that banks look at when extending credit. A debt to worth ratio of two or less is generally considered reasonable and safe. A debt to worth ratio of four or higher is a signal to creditors that a firm may be over relying on debt to finance its operations and is therefore becoming a possible credit risk. A firm in this condition is said to be highly leveraged (the amount of debt in the firm relative to the owners’ equity stake).

Our second balance sheet ratio, the current ratio, is current assets divided by current liabilities. A current ratio of two to one or higher is desirable. A current ratio of two to one is saying that for every dollar of debt obligation coming due over the coming twelve months, the firm has two dollars of cash (or assets that will convert to cash over that period) to meet its obligation. Creditors look to the current ratio, as a key indicator of how likely a firm is to make its future payments in a timely fashion. The higher the current ratio, the more “liquidity” the firm is said to have.

Each of these ratios and indicators should be readily attainable from your internal accounting system. Get in the habit of having your accounting person (or outside accountant if need be) generate this information for you each month and, over time, learn to interpret changes and patterns to help you better manage your firm.

Wahby and Associates