Your financial statements hold so much valuable data within them that allow you to understand not just how well your architecture and engineering (AE) firm has performed, but also how it might perform in the future. But the statements themselves hold little value until you know how to analyze them, what to look for, and how to use that information to drive growth and improvement.
Analyzing your financial statements is critical to effectively manage your AE firm. Knowing your financial ratios is an important tool in helping you understand and improve your financial results. A firm’s financial performance should not only be compared to prior years, but also to the results of competitors and industry standards.
The first questions to consider are whether your current internal financial reports provide you with all of the information needed and whether decision making could be improved if better financial data were provided? The balance sheet and income statements are only the starting point for successful financial management. A firm must also understand and utilize the detailed reporting available within its accounting system.
So, how can improved financial statement analysis help you? Streamlining your accounting reports can assist in locating and correcting accounting errors, identify areas for business improvement, and enable you to react to problems more quickly. This will also allow you to better understand the interrelationship of accounts, which in turn will help you devise better solutions for the problems identified.
Financial statement analysis will also assist in monitoring the success and failures of business initiatives and help to identify more business opportunities. This will lead to establishing better terms for proposals and contracts and enable you to monitor your performance on existing jobs.
To ensure your financial analysis is effective, you must firms capture all relevant data related while also ensuring that data is high quality. Tasks such as capturing time consistently, preparing account reconciliations and closing out the accounting ledger on a money basis are critical to effective reporting. Remember the adage of “garbage in, garbage out.”
In the AE industry, many smaller firms operate strictly on the cash method of accounting because of its ease of use and it is advantageous for income tax reporting. However, it is not appropriate and should not be used for financial reporting. In a professional service firm, the cash method of accounting significantly understates the firm’s net worth. When income and expenses are not properly matched in the same accounting period, profitability is distorted. Accounting software packages often provide both cash and accrual financial statement reporting options.
The balance sheet represents a snapshot of the financial position of a firm at a specific point in time. The most significant assets are typically accounts receivable and work in process. The income statement is a period-to-date summary of revenue and expenses that calculates the net income or loss for the period. The income statement for a professional service firm differs significantly from other types of entities. The bottom line net income is not truly representative of the firm’s profitability due to discretionary bonuses paid to a firm’s owners. The proper income statement format is essential in order to manage the firm for profitability in addition to assisting in providing comparisons with peer firms in the industry.
Key elements of the firm’s income statement include gross revenue and net revenue. Gross revenue represents gross fees billed to clients including reimbursable expenses. Net revenue is gross revenue less reimbursable expenses. This is the revenue earned on the firm’s labor and is used as a basis for providing income statement comparisons with prior periods and industry standards. Direct labor is utilized in many financial ratios and metrics for AE firms. The industry standard percentage of direct labor to net revenue is often in the range of 32% to 34%. The contribution margin represents the firm’s net fee revenue less direct labor and project expenses. This is the firm’s contribution to cover overhead expenses and provides for net profit.
A guideline for the industry standard gross profit percentage is often in the 66% to 68% range. Indirect costs – your firm’s overhead – include expenses such as administrative labor, benefits, insurance, occupancy costs, and office expenses. The most significant performance measure of the firm’s profitability is net income before discretionary items, which often is in the range of 10% to 15%.
A fairly easy improvement to your monthly financial statements is to include comparisons to prior years. Monthly financial statements should include fluctuations showing both dollar and percentage changes. The income statement should include both current month and year-to-date amounts as a comparison to the prior years. The financials should also include the appropriate level of detail and be reported by division and location.
The income statement should be presented in the appropriate format specific for professional service firms to include separate categories for gross revenue, reimbursable expenses, net revenues, direct labor, direct expenses and overhead.
Going beyond the basis financial statement is the next step in analyzing the success, failure, and progress of your business. Fluctuation analysis is a study of changes in amounts from period to period by both dollar change and percentage change. Understanding the relationship among different balances and identifying unusual fluctuations is essential to better understanding your firm’s financial performance.
Utilizing budgets and forecasts are necessary for running an effective business. Detailed budgets can be used to compare variances between actual and planned performance. With a proper budget to analyze, management is able to quickly identify and respond to variances to get operations back on track. Too often, a significant amount of time is spent preparing budgets that are not utilized during the year. Budgets are only useful if they are being used in analysis.
Performing ratio analysis and benchmarking can also provide additional insights into the operations of a firm. Ratios can serve as benchmarks against which the firm can evaluate itself. There are several key financial statement ratios specific to AE firms which are detailed below.
Financial analysts group ratios into categories which tell us about different facets of a firm’s finances and operations.
Leverage ratios show the extent of debt that is used in a firm’s capital structure. Solvency ratios give a picture of a firm’s ability to generate cash flow and pay its financial obligations. Formulas for important leverage and solvency ratios include:
For professional service firms, the most significant measure of economic benefit available to owners is a firm’s net income before discretionary items and taxes. This measure of net income reflects the firm’s operating income available to be distributed to the firm’s owners. The firm’s net income before discretionary items and taxes represents its annual earnings before bonuses and profit-sharing contributions. This ratio provides a strong indication of its true earning capacity. The formula for net income before discretionary items and taxes to net revenues is:
Contribution margin is the firm’s ratio of net revenue after direct labor expended on projects compared to the firm’s revenue. This ratio measures the firm’s contribution to cover overhead (indirect) expenses and to provide for pre-discretionary profitability. The formula for contribution margin is:
The chargeability ratio demonstrates the percentage of total staff time charged directly to projects and is a great measure of labor efficiency. Smaller firms are typically characterized by higher chargeability while larger firms have additional administrative personnel. Another labor ratio compares the total indirect labor to direct labor to measure the mix of billable vs. non-billable labor costs. The net multiplier achieved provides a relationship of the firm’s net revenue earned as compared to direct project labor expended on contracts in order to measure the effectiveness of the firm’s utilization.
The net multiplier target is typically 3.0 and is used to set fees and prepare budgets. The payroll multiplier represents the ratio of the firm’s net revenue to total labor and measures the net revenue earned by the firm per dollar of total labor expended. Formulas for important labor ratios include:
Overhead ratios are also a focus for many firms. An AE firm’s overhead rate is the ratio of all indirect overhead expenses, either before or after discretionary items, compared to the total direct labor on projects.
Another overhead ratio is a comparison to overall net revenue. Formulas for important overhead ratios include:
A single ratio or fluctuation will not give you enough information to make a judgement about your firm and cannot be interpreted in a vacuum. A ratio merely points out what needs to be investigated and you must have additional data to evaluate.
Firms should use targeted financial ratios as a means to meet their goals for profitability and long-term planning. For example, the firm might target the following income statement ratios:
Industry comparisons are a great measure of your firm’s performance in relationship to other firms to evaluate your operating efficiency. The AE industry has excellent data available for all size levels of firms and industry comparisons must be a part of the firm’s financial analysis. Sources of industry data include:
Compare your firm to the industry average or median data to see how you measure up to your competition.
Effective financial analysis is a four-step process to prepare the proper reports, distribute the reports to the proper personnel, perform analysis, and make management decisions based upon the analysis.
Consider how much time is spent by your firm to produce financial data versus the time spent using the data. Make sure your firm takes the time to perform data analysis every month. Financial analysis should also be documented and shared with others within the firm, as it is only effective when followed up upon and action is taken. Recognize that change is needed to achieve improved results, however, be certain to analyze the cost versus benefit of any financial decision.
When it’s done the right way with quality data, financial analysis is a powerful tool that can help you run your firm more effectively and profitability.
Victor W. Vaccaro, Jr., CPA/ABV, CFF, CDA, is the partner-in-charge of assurance services. Vic has over 34 years of experience providing auditing, accounting and consulting services. He specializes in working with manufacturing companies and architectural and engineering firms.
Vic’s areas of expertise include FAR overhead audits, business valuations, ownership transition, mergers and acquisitions and forensic accounting. In addition, he focuses on consulting engagements designed to enhance the profitability of his clients, including implementation of performance management techniques, activity based costing projects, customer profitability analysis, improved budgeting and strategic planning initiatives. Vic is also the partner-in-charge of the firm’s manufacturing practice group.