Financial Ratios To Stress-Test Your Business

Editor's Note: This article is based on Vicki LaPlant's presentation at HVAC Comfortech 2010 conference. Please check out www.hvaccomfortech.com for a run down of the 2011 program in Indianapolis and register online today.

Each year, you see a doctor who analyzes your general physical condition. Once you reach a certain age, a good doctor will insist upon a stress test to insure that your heart, the central muscle of your body, is working effectively and efficiently. And just as your good health may depend on a stress test, the good health of your business depends on periodic, consistent, stress testing.

A doctor analyzes the numbers and looks for certain ranges. You also must examine the numbers generated by your business to determine if they’re in the right range.

Traditional Financial Ratios
There are several of these ratios that your accounting software should automatically generate reports for each month. These traditional ratios are divided into three categories: profitability, solvency and efficiency.

Profitability ratios, such as return on assets and return on net worth, communicate how hard the company is working to generate profits.

Solvency ratios, such as working capital, current, and quick ratios, analyze the debt load of a company.

Efficiency ratios, such as collection period, sales-to-assets, and sales-to-net working capital, analyze how efficiently the company is managing major assets such as accounts receivable, inventory, and fixed assets.

Determine which traditional ratios provide you information about your company operations and make a real effort to monitor and track them each month. Set a point on a graph of the company’s current performance of these key ratios, determine the desired performance for each, and watch your progress. Often the best measure of performance is based on past performance.

Stress Management Ratios
There are four key ratios we recommend for managing stress. Two of them are covered here and the others can be found online (See the sidebar, "Financial Ratios List" on this page).

Let's start with the measurements used to see if you can sleep well at night.

There are several "How Well Are You Sleeping?" ratios, but break-even is by far the most important. Managers should know this number and base operational, marketing, and profit decisions on it.

A company reaches break-even when it has generated enough sales volume to cover overhead and all direct costs incurred to date. Another way of defining break-even is when Gross Margin equals Overhead.

Break-even can be calculated on a monthly and annual basis. Unfortunately, for most HVAC and plumbing contractors, companies tend to reach break-even near the end of November or early December. Only after all direct costs and operating expenses have been paid does the company generate a profit.

The formula to calculate break-even is simple division:

Annual Break-even Sales Volume =
$ Annual Overhead / Annual Gross Margin %.

For example, a company with projected annual overhead of $300,000 with a 35% gross margin has a break-even sales volume of $857,142.

In this example, the company pays for all the overhead projected for the year when it reaches $857,000 in sales. From that point on, until the end of the year, every sales dollar generated, once direct cost of equipment, material and labor have been subtracted, drop to the net profit line because overhead / operating expenses have been paid.

Make break-even work for your company by calculating it on a monthly basis. Either project or estimate your monthly operating/overhead expenses and divide this by the gross margin percentage. This calculation shows the minimum monthly sales volume required to cover monthly overhead expenses.

With this information, you can make adjustments in pricing, marketing, and promotion strategy.

For example, if it’s the 15th of a month and you've only achieved 25% of the sales volume required to hit a monthly break-even, implement a consumer promotion, provide additional incentive to the sales force, or a bonus to service technicians for adding accessories on tune-ups, and service calls. Now rather than letting profits happen, you begin to control profits by knowing what sales must be and driving to that number.

"Just Do It" ratios include the average selling price for either an installation or service invoice. These ratios should serve as a daily reminder of the effectiveness of the company's pricing strategy, promotions, and marketing efforts. One such ratio, known as the bundling ratio, focuses on a company's ability to up-sell and generate accessory sales.

The bundling ratio shows what percentage of a company’s total installation invoices were for higher efficiency equipment and/or accessory items. These two items not only increase sales, but typically generate a higher gross profit.

The formula to calculate this percentage is:

# Value Added Jobs / # Total Installs

Including a maintenance agreement doesn't count as a value added job, because that should be an automatic inclusion for every install. Our recommendation is that 60% of your total installations should be a value added job.

How is that accomplished? Best, better, good equipment pricing should include accessories with each price level, in addition to stepping up equipment efficiency.

Don't offer all accessories as an addition to the package price; instead only include certain accessories with the package. Incentivize the sales crew to offer accessories not purchased at time of sale (perhaps with an added incentive to the homeowner) on the day of installation.

Pay sales people a percentage of the total dollar volume of installation, but slide the percentage based on gross margin percent. Gross margin percent should generally be higher on accessories, driving up the gross margin percentage of total installation.

Stress-Test Your Business: Two More Financial Ratios to Consider
As part of her presentation at HVAC Comfortech 2011, in Baltimore, MD, speaker Vicki LaPlant provided HVAC contractors with some tools on how to measure the success of their companies.

She called these tools, Stress Test Financial Ratios.

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Two not covered in the original article published in the July 2011 issue Contracting Business.com magazine are the "Am I Charging Enough?" ratio and the "Am I Building Value?" ratio.

"Am I Charging Enough?" Ratios
The key measurement of whether a company is charging enough for its goods and services is if ownership is satisfied with its bottom line profitability. But many factors, in addition to pricing, impact net profit. As a result, several other performance factors should be evaluated including:

  • Gross margin dollars per day
  • Gross margin dollars per crew
  • Gross margin dollars per type of work
  • Gross margin dollars per service technician.

Closing rates should also be tracked. Depending on the source of the lead, a closing rate that’s too high indicates prices are too low. Closing rates that are too low can indicate prices being too high.

But we believe one underused measurement is the percentage of low labor installations to total installations. If your company must choose between an installation requiring double the labor cost versus one requiring less labor cost, which one do you want? If you're like 99.9% of the contractors to whom we ask that question, you want the lower labor cost job, because you can get a second installation with the extra labor, producing an increase in sales, gross margin, and net profit dollars.

We define a low labor installation as one where the actual payroll cost for the installers to complete the installation is less than 20% of the total direct cost (equipment, material, and labor) estimated for the job.

A low labor job allows more pricing flexibility.

If your street rate for service labor is set at a 60%+ gross margin, then the gross margin on a low labor job can be set at as low as 35% with 13 to 15% of that going to net profit. Low labor jobs can be used to grow top line sales quickly and profitably. A strategic pricing strategy allows that to happen.

Our recommendation is that 50% of your total residential/replacement installations should be low labor. This target means better management of the installation and service job board.

"Am I Building Value?" Ratios
Determining the value of a company involves many factors. A common misconception is that the value of a contracting business can be determined as some multiple of earnings or sales — I believe that just isn't a fair method for either the buyer or seller.

As an owner, building value in your company involves numerous factors, including accessibility of your data base, recurring revenue streams, revenue stream guaranteed by maintenance agreement customers, percentage of your active customer base versus total customer base, and percentage of total sales from the active customer base. By the way, an active customer is defined as one who has spent money with your company in the past 12 months.

Of these, the one that's most important in determining the value of an existing company is the annual revenue from the maintenance agreement customer base.

First, this measurement means that having a large percentage of your customers tied to the company through maintenance agreements is critical for its long-term value.

Next, it means your company must have systems in place that actually track, not only purchases of maintenance agreements in a 12-month period, but also the purchases of customers recommended to your company by maintenance agreement customers.

After all, maintenance agreement customers actually know your name, like your company, and continue to desire your service on an annual basis. This means they actually recommend you to friends, neighbors and relatives. Customer incentives certainly help facilitate this process.

To determine the revenue from your maintenance agreement customer base on an annual basis, add the total purchases from your existing customer base plus the purchases from customers referred by maintenance agreement customers.

This dollar amount, particularly if it can be verified for two or three years, is a good guarantee of the sales revenue that can be generated each year from your maintenance agreement base before any additional marketing and advertising is implemented. This is a strong indicator of a company’s value.

In the end, your age (translate as where the company and its ownership are in their life cycle) will determine which ratios are most important in your business. The key to stress testing your business is to choose those numbers that are most important for the next five years of the company’s life cycle and focus on determining and improving those.

Vicki LaPlant has been working with HVAC contractors for the past 30 years as a trainer and consultant. She is expert in helping people work better together for greater success. She is a Contracting Business.com editorial advisory board member and can be reached by email at [email protected], or by phone at 903/786-6262.

Financial Ratios List
Laplant highlights six ratios for contractors to use to "stress-test" their businesses. The six ratios are as follows:

  • Traditional Financial Ratios
  • Stress Management Ratios
  • How Well Are You Sleeping? ratios
  • "Just Do It" ratios
  • Am I Charging Enough? ratios
  • Am I Building Value? ratios

To read about the last two ratios in detail, go to bit.ly/Ratios_Sidebar.

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