Financial Key Performance Indicators (KPIs) for Homebuilding: Part 2
Liquidity Ratios are critical to any business's longevity because they illustrate the ability to repay debt. Liquidity is defined as the ability to convert assets into cash. The Current Ratio focuses on current debts payable with current cash & assets. Current Assets refer to money and assets convertible to cash within 12 months, and Current Liabilities are any debts payable within 12 months. When Current Liabilities are subtracted from Current Assets, the difference is Working Capital and is a good measure of a business’s ability to expand or grow.
Current Ratio = Current Assets / Current Liabilities
A low Current Ratio illustrates a capital shortfall and market cycle or revenue vulnerability, whereas a high ratio shows more liquidity but the inadequate use of resources. A calculation close to 2 is desired, but 1.5 is often typical in homebuilding. A more stringent test of a company’s liquidity is the Acid Test Ratio which uses “quick” assets instead of current assets.
Acid Test Ratio = Quick Assets / Current Liabilities
“Quick” is considered assets convertible to cash within 30 days. Historically, the Asset Test Ratio is a very low calculation in Homebuilding because inventory is not easily converted to cash. This is an industry with heavy financing and considerable inventory.
Leverage Ratios measure the financial risk of the operation and illustrate the risk for the lenders and investors. Owners’ Equity to Total Assets Ratio shows what percentage of the assets are financed by owners' investment instead of borrowed funds; therefore, the higher this percentage, the lower the risk to investors or lenders.
Owners’ Equity to Total Assets Ratio = Owners’ Equity / Assets
Another leverage ratio is Total Liabilities to Owners’ Equity, where a lower ratio show’s a stronger ownership position or lower risk for lenders or investors. Many factors affect whether this calculation is a high risk, including personal guarantees or personal assets as collateral.
Total Liabilities to Owners’ Equity = Liabilities / Owners’ Equity
Return on Investment ratios are likely the most widely known of all the KPI ratios. They are defined by either the total assets (resources) or a business or the owner’s invested capital.
Return on Assets ratio = Net Profit / total assets
Return on Owners’ Investment ratio = Net Profit / Owners’ Equity
Return on Owners’ Investment can be interchangeable with the term Return on Investment (ROI). This is not a Return on Total Investment. This ROI ratio can also be formulated as a product of three ratios; net profit, efficient use of capital, and the amount of debt leverage. The three formula relationships are as follows:
Return on Investments = Return on Sales X Asset Turnover X Leverage
Profit / Equity = Profits / Sales X Sales / Assets X Assets / Equity
The Leverage is a setting of your investment risk level, meaning the higher the leverage, the higher the risk. Improvements (or increases) in any of these ratios improve the ROI, but care must be taken with the balance of leverage and associated risks.