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.