“Let’s Add Some Science To Our Business”
Some years back my surety consulting firm tackled job after job completing failed construction projects for the bonding companies that were increasingly having to finish failed projects. As one assignment followed another, I began to ask myself the same questions over and over;
“Why didn’t management or the surety see this coming?
“What was it about the way my clients were looking at companies that encouraged them to issue bonds only to be surprised when their completion guarantee was called upon?”
“What were we not seeing during financial evaluations?”
I began to realize that the traditional financial ratios we always relied on to tell us “the financial story” were not telling us enough, or we weren’t listening. Something was lacking in the usefulness of the financial data that both construction firms and credit grantors were using to make important decisions.
Traditional Financial Ratios
NET PROFIT – During my research to discover the warning flags of potential failure, I discovered that net profit, although a measure of current success, is not a good indicator of future risk in the construction business. For example, a company with sales of $10 million annually that grows to $20 million in a year, without a corresponding increase in equity, may dramatically increase financial risk without realizing it, even if profitability is maintained.
GROSS PROFIT – Going back up the chain to look at gross profit as an indicator of how efficient a contractor was at the job level, we realized that the usefulness of those numbers was also suspect because there was no agreement among contractors on what is charged to the job and what is charged to overhead.
EQUITY – Originally, we thought that the equity reported on the balance sheet should at least tell us how stable a company might be, until further research demonstrated that different construction concerns have very different capital structures. For example, a heavy highway company that owned its own equipment would have a fixed asset-rich capital structure; whereas a CM firm or specialty subcontractor with limited fixed assets would be better served by an abundance of liquid capital. It was virtually impossible to make a meaningful comparison among the wide variety of construction enterprises.
Adding Some Science
Traditional financial ratios are a snapshot of a company’s current performance and not a predictor of future success. I gradually became convinced that the warning signs (indicators of potential financial strength or weakness) must exist in the financial records of closely held construction companies, but that we were interpreting the available information incorrectly. We needed to create a data point that would accurately define our financial condition (strength or weakness). It became apparent that we needed better financial indicators to properly evaluate companies. Too many companies were surprising themselves by suddenly folding up and falling back on their bonding to complete projects in progress. In short, we needed a formula that could measure financial strength and potential future success. After four years of research, I came up with what became known as the R-Score.
R-Score Formula – Measures the stability of a company’s available capital as it moves through the natural growth cycles of the construction industry.
The essence of this formula is based on two simple insights:
- There is a difference between performance measures and financial measures.
- There is a difference between profit and available profit.
The stability of available capital – not profit or equity or even a robust current ratio, was the indicator of the financial condition of a construction enterprise and the amount of risk it was at–at any given point in time.
R = R-Score – a numeric measurement of financial risk.
NP =Net Profit
S = Sales
TL = Total Liabilities
TA = Total Assets
E = Equity
R = (1-NP/S-(10(TL/(TL+TA)) (NP/S))) (S/TA) (TL/E)
- Test data reveals that lower R-Scores indicate low financial risk; higher scores indicate that financial resources are stretched. See “Read More” below to get more detail on the meaning of scores.
- Your R-Score trend is more important than your raw score. Determine what your score was five years ago, four, three, two, one, etc. If it is rising there is a shift in risk (financial strength) in the wrong direction. If it is going down, keep doing what you are doing.
This complex formula is available on this site in free, easy-to-use software. Go to “Tools” in the top menu bar and download it free. Input your company data from annual financial statements and the R-Score software will generate multi-year calculations, including graphic presentations and text explanations of the meanings and trends. Read more about Financial Risk here