February 3, 2020
KPIs are used to determine if a contractor’s business is profitable and is on track to achieve the company’s stated goals. While overall company and job profits are the strongest KPIs to watch, work in progress (WIP) can be equally as important. WIP is what a contractor invests in delivering a completed contract. WIP includes materials, labor, and overhead.
Financial KPIs
The four major categories of financial KPIs are:
- Profitability – Return on assets, return on equity, and times interest earned
- Liquidity – Current ratio, quick ratio, days of cash, and working capital turnover
- Leverage – Debt, under-billings, backlog and revenue to equity, asset turnover, fixed asset ratio equity to selling, as well as general and administrative expense
- Efficiency – Backlog to working capital, months in backlog, days in accounts receivable, inventory, accounts payable, and operating cycle.
Non-Financial KPIs
Non-financial KPIs should be considered as well. They can provide valuable insight on the drivers of a contractor’s financial results. Some non-financial KPIs include:
- Labor hours
- Cost exceeding budget
- Productivity below estimates
- Defects found
- Safety incidents
Track KPIs Over Time
It is important to track KPIs over time to determine if you are making progress towards meeting your goals. Financial indicators gauge if the company is growing, shrinking, making or losing money, or maintaining its performance. By tracking profit margin, revenue compared to budget, cost of goods sold, and other financial KPIs you can determine trends in expenses, cash flow and revenue growth.
Impact of the New Revenue Recognition Standard
The Financial Accounting Standards Board (FASB) introduced Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers (Topic 606) on May 18, 2014. This ASU will significantly affect the revenue recognition practices of most companies.
Contractors are required to maintain the financial metrics outlined in the terms of a bond agreement. This can include everything from minimum working capital ratio and maximum debt-to-equity ratio requirements. The timing and amount of revenue reported may change these metrics resulting in the contractor being out of compliance with the terms of their agreement.
The ASU requires that revenue is recognized when the good or service is transferred, or as control over the good or service is transferred. Revenue can be recognized either over time (services) or at a point in time (goods).
The timing of contract-related costs could impact a company’s balance sheet. Contract accounts may need to be reorganized which will change presentation of contract-related assets and liabilities on the balance sheet. Although adjustments to a contractor’s financial statement may not be material, an analysis should be performed to determine what areas, if any, will be significantly impacted.
Impact of the New Lease Accounting Standard
The new lease accounting standard (ASU No. 2016-02, Leases. Topic 842) was issued by the Financial Accounting Standards Board (FASB) in February 2016. The ASU applies to related party leases based on the “legally enforceable” terms of the agreement. Short-term leases of 12 months or less that do not include an option to renew may be exempt.
This ASU will impact a contractor’s:
- Balance Sheet – Lease obligations generally increase assets and liabilities.
- Financial Ratios – A contractor’s working capital ratio and debt-to-equity ratio may be pushed above the acceptable threshold.
- Expense Recognition – Capital leases typically result in accelerated expense recognition for financial statement purposes under the ASU. Operating leases have a constant annual cost. The “right-of-use” cost can generally be amortized over the lease term on a straight-line basis. The lease liability is based on an effective interest rate calculation.
- Sale and Leaseback Transactions – Real estate transactions may qualify for sale and leaseback accounting.
- Taxable Income and Deductions – Contractors may have to recognize deferred assets and deferred liabilities in reporting excess on “right-of-use” assets and the related lease liabilities according to generally accepted accounting principles (GAAP).
- Valuation Allowance – Changes recorded in deferred tax assets and liabilities, as well as how book-to-tax differences are reversed under the ASU. A contractor’s valuation allowance and net operating loss (NOL) carry forwards can be impacted.
There are many other factors to consider regarding this ASU, such as the tax implications of leverage leases; state sales and use taxes, franchise, net worth, and other non- income-based taxes; and interest expense, personal property or real estate taxes and transfer pricing.
A contractor’s KPIs may be negatively impacted the new revenue recognition and lease accounting standards. Sureties need to be aware that a contractor’s financial results may be under or overstated.
Sureties may need to look beyond the numbers during this transition period. In most cases, a true year-over-year or month-over-month comparison of a contractor’s KPIs will not be possible during the initial transition to these ASUs. The contractor’s CPA can explain the changes in KPIs and provide a pro forma and/or analysis of the changes to their client’s balance sheet and financial ratios because of these ASUs.
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Martin C. McCarthy, CPA, CCIFP
Managing Partner
McCarthy & Company, PC
Disclaimer: This alert is for informational purposes only and does not constitute professional advice. Information contained in this communication is not intended or written to be used as tax advice, and cannot be used by the recipient to avoid penalties that may be imposed under the Internal Revenue Code. We strongly advise you to seek professional assistance with respect to your specific issue(s).
