Looking for a Vital Sign in Contractor Accounts: The Receivables/Payables Ratio
continued
page 4 of 4
page 1 | 2 | 3 | 4
Facts: Double Your Money
In fact, contractors have kept this ratio above 2.0X, on average, over the past 20 years, according to RMA statistics for the receivables/ payables ratio (see Figure 3).
The ratio varies from line to line, but the variation tends to reflect the differences among contractors in proportions of labor and materials. For example, painting contractors have much higher labor costs proportionately than bridge contractors, whose material costs are relatively higher than those of painters.
Interpretation: Two is Good; Under One, Not So Good
Generally speaking, the receivables/payables ratio has averaged over 2.0X although it does vary from this overall average depending on the labor/materials proportion in the individual contractor line of business as noted in the table above. It has already been established conceptually that whether calculating the ratio by comparing the total billing to the material cost component or just comparing the receivables turnover to payables turnover, the ratio tends to lie somewhere between 3.3X and 1.67X. Remember that the apparent slowness in receivables is actually the weighted average impact of retention on collection of a project's net progress billings during construction and then the wait for the 10% retention after the entire job is certified as complete.
So what is an unacceptable level? Ratios below 1.0X clearly tax the patience of trade creditors.As noted earlier in this article, a ratio of 1.0X or lower infers substantial slowness, perhaps in the 60- to 90-day range. That degree of slowness usually warrants COD treatment from suppliers. In fact, anecdotal evidence over the years confirms that contractors with such a low receivables/ payables ratio do show past-due payables, COD terms, judgments, liens, and collection activity in their trade credit reports. If suppliers will not ship materials, the contractor cannot continue to build. Once the contractor ceases work, so ceases payment. The cessation of cash ultimately means a problem asset for the lender.
Advantages: Easy to Use and Track
This ratio is easy to calculate. A current balance sheet or even just a current set of agings for receivables and payables may suffice. Unlike the turnover ratios, the receivables/ payables ratio does not require an income statement. The agings offer the additional advantage of insight into the quality of customer receivables and the immediacy of trade debt pressure. A receivables aging that distinguishes the amount of retention from the net progress billing gives the reader a better sense of the timing and relative sizes of the cash flows from billings and retention. A payables aging reveals the proportion of current and not-so-current trade debt, and the aging's currency or delinquency can be compared with trade credit reports to double-check the accuracy of the aging.
The ratio can be used at the front end of the credit decision process as a screen and after the credit is extended as a monitoring tool. If used in conjunction with periodic trade credit reports, the receivables/payables ratio may be a cost-effective way of screening and monitoring contractors. Set the screen at a minimum of 1.0X for the receivables/payables ratio, and track the ratio's trend for deterioration below the industry average or below the 1.0X minimum.
Closing and Summary: Take the High Road
The receivables/payables ratio is a quick-and-easy test of contractor viability. History indicates that this ratio has averaged over 2.0X, varying among the contractor
lines depending on the
proportion of labor and materials. The more labor costs relative to material costs, the higher the ratio.
Regardless of the labormaterial costs, the ratio runs well above 1.0X. When the ratio falls below 1.0X, the contractor is likely to be seriously past due on trade debt, a condition that is perilous to lenders. Thus, the value of this ratio in the credit process is, in the front end, as a screen and, during the life of the commitment, as a monitor.
Take advantage of the analytical and monitoring power of this ratio to keep your contractors moving on down the road to success. Otherwise, to paraphrase Will Rogers, even if you're on the right road, you'll still get run over if you just sit there.
«HOME