Financial analysis, planning and capstone: a financial health review

The previous lessons built Kestrel Builders' financial picture piece by piece: its statements, revenue recognition, WIP schedule, overhead, equipment, cash, financing, taxes and bonding. This final lesson brings the pieces together. It introduces the ratios and benchmarks used to analyze a contractor, shows how to read trends rather than single numbers, sets out a simple framework for an annual financial plan, and then works through a complete financial health review of Kestrel at the end of 2025, of the kind a controller would present to the owners, or a surety analyst would prepare for the file.

Ratio analysis for contractors

Ratios turn the statements into comparable measures. For contractors they fall into five groups: liquidity, leverage, profitability, efficiency and backlog. Each ratio answers a specific question; none is meaningful alone.

bs = dict(ca=13_950_000, cl=11_500_000, tl=12_750_000, eq=4_400_000, eq_open=3_520_000,
          ta=17_150_000, ar=6_900_000, ap=5_800_000, under=1_150_000, over=2_250_000, cash=2_850_000)
inc = dict(rev=58_400_000, cost=53_440_000, ga=3_300_000, ni=1_230_000)
backlog = 41_000_000
wc = bs["ca"] - bs["cl"]
r = {
    "current ratio": bs["ca"] / bs["cl"],
    "working capital / revenue": wc / inc["rev"],
    "debt to equity": bs["tl"] / bs["eq"],
    "revenue to equity": inc["rev"] / bs["eq"],
    "gross margin": (inc["rev"] - inc["cost"]) / inc["rev"],
    "overhead ratio": inc["ga"] / inc["rev"],
    "return on equity": inc["ni"] / ((bs["eq"] + bs["eq_open"]) / 2),
    "days of receivables": bs["ar"] / (inc["rev"] / 365),
    "days of payables": bs["ap"] / (inc["cost"] / 365),
    "backlog / working capital": backlog / wc,
    "months of backlog": backlog / (inc["rev"] / 12),
    "underbillings / equity": bs["under"] / bs["eq"],
}
for k, v in r.items():
    pct = k in ("working capital / revenue", "gross margin", "overhead ratio",
                "return on equity", "underbillings / equity")
    print(f"{k:28} {v:8.1%}" if pct else f"{k:28} {v:8.2f}")

current ratio                    1.21
working capital / revenue        4.2%
debt to equity                   2.90
revenue to equity               13.27
gross margin                     8.5%
overhead ratio                   5.7%
return on equity                31.1%
days of receivables             43.12
days of payables                39.61
backlog / working capital       16.73
months of backlog                8.42
underbillings / equity          26.1%

Benchmarks and their limits

Contractors compare their ratios with industry benchmarks such as the Construction Financial Management Association's annual benchmarking survey, surety and bank surveys, and IRS and Census data by industry. Benchmarks are useful for spotting outliers, but they need care. They mix firms of different size, trade and accounting policy; they are usually medians, so half of healthy firms fall on each side; and a general contractor and a mechanical contractor should not be compared with the same yardstick. The trend in a firm's own ratios over three to five years is usually more informative than a single comparison with an industry median.

The trend tells a clearer story than any single year. Kestrel has grown about 15 % a year and has kept its equity growing roughly in step. But gross margin has slipped every year, working capital has not kept pace with revenue, and completed jobs have finished progressively further below their earlier estimates. These are the early signs of growth beyond capacity described in Lesson 1, even though every year has been profitable.

A screening score

Researchers have built scores that combine ratios to predict financial distress. The best known is Edward Altman's Z-score, first published in 1968, and its later variants. A version designed for non-manufacturing private firms, often called Z″, weights four ratios. It is a screening tool only: it was not built for contractors, it uses book values that depend on revenue recognition estimates, and it should prompt questions, not conclusions.

Here X₁ is working capital divided by total assets, X₂ retained earnings divided by total assets, X₃ earnings before interest and taxes divided by total assets, and X₄ book equity divided by total liabilities. Commonly cited zones are above about 2.6 as relatively safe, between about 1.1 and 2.6 as a gray zone, and below about 1.1 as a distress zone.

ta, wc, re, ebit, eq, tl = 17_150_000, 2_450_000, 4_200_000, 1_700_000, 4_400_000, 12_750_000
x = [wc / ta, re / ta, ebit / ta, eq / tl]
w = [6.56, 3.26, 6.72, 1.05]
z = sum(a * b for a, b in zip(w, x))
print("Ratios:", ", ".join(f"{v:.3f}" for v in x))
print(f"Z'' score: {z:.2f}")
# The same firm after a 1.5 million loss on one job
loss = 1_500_000
x2 = [(wc - loss) / (ta - loss), (re - loss) / (ta - loss), (ebit - loss) / (ta - loss),
      (eq - loss) / tl]
print(f"Z'' after a 1.5M job loss: {sum(a * b for a, b in zip(w, x2)):.2f}")

Ratios: 0.143, 0.245, 0.099, 0.345
Z'' score: 2.76
Z'' after a 1.5M job loss: 1.29

Kestrel scores about 2.76, just inside the safer range. A single loss of $1.5 million, about the size of the gross profit on its largest job, would drop it into the gray zone. That sensitivity, rather than the score itself, is the useful insight: a contractor's financial health can change quickly because its equity is small relative to its volume.

The annual financial plan

Most well-run contractors prepare an annual plan that turns the business strategy into numbers: expected revenue from backlog and new work, gross margin by type of work, overhead budget, equipment spending, cash flow, financing and the resulting balance sheet and ratios. The plan becomes the benchmark for monthly results and the basis for discussions with the surety and bank.

rev = 64_000_000
gm, overhead, interest, tax_rate = 0.084, 3_550_000, 150_000, 0.215
for name, r, g in (("Plan", rev, gm), ("Downside", 52_000_000, 0.072), ("Upside", 68_000_000, 0.088)):
    op = r * g - overhead
    ni = (op - interest) * (1 - tax_rate)
    wc_end = 2_450_000 + ni - 250_000 - 0.2 * 700_000      # retained profit less unfinanced equipment
    print(f"{name:8}: revenue {r / 1e6:4.0f}M, operating income {op:>10,.0f}, "
          f"net income {ni:>10,.0f}, year-end working capital {wc_end:>10,.0f}")

Plan    : revenue   64M, operating income  1,826,000, net income  1,315,660, year-end working capital  3,375,660
Downside: revenue   52M, operating income    194,000, net income     34,540, year-end working capital  2,094,540
Upside  : revenue   68M, operating income  2,434,000, net income  1,792,940, year-end working capital  3,852,940

The plan meets the $3.0 million working capital target with a little room. The downside case, with revenue of $52 million at a 7.2 % margin, leaves operating income near zero and working capital slightly lower than today; Kestrel would still be solvent, but its surety would see three years of improvement undone. Scenario analysis like this helps management decide in advance what it would cut, and when, if the downside starts to appear.

Backlog and overhead coverage

One of the most revealing planning measures is how much gross profit is locked into the backlog compared with next year's overhead. If the backlog's remaining gross profit covers most of the overhead, the firm can be selective about new work; if it covers little, the firm is under pressure to win work quickly, which is when contractors bid too low.

contracts = [14_600_000, 3_850_000, 21_400_000, 6_900_000, 9_200_000, 7_750_000, 4_300_000]
est_cost  = [13_250_000, 3_520_000, 19_800_000, 6_780_000, 8_330_000, 7_900_000, 3_850_000]
cost_td   = [9_940_000, 2_710_000, 7_120_000, 5_650_000, 1_240_000, 2_860_000, 620_000]
rev_td = [c * t / e for c, e, t in zip(contracts, est_cost, cost_td)]
remaining_rev = sum(contracts) - sum(rev_td)
remaining_gp = sum(max(c - e, 0) for c, e in zip(contracts, est_cost)) - sum(
    max(r - t, 0) for r, t, c, e in zip(rev_td, cost_td, contracts, est_cost) if c > e)
signed_not_started, its_margin = 5_230_000, 0.08
backlog = remaining_rev + signed_not_started
gp_in_backlog = remaining_gp + signed_not_started * its_margin
print(f"Revenue to be earned on open jobs: {remaining_rev:,.0f}")
print(f"Total backlog: {backlog:,.0f}")
print(f"Gross profit remaining in backlog: {gp_in_backlog:,.0f}")
print(f"Months of 2026 overhead covered: {gp_in_backlog / (3_550_000 / 12):.1f}")

Revenue to be earned on open jobs: 35,770,158
Total backlog: 41,000,158
Gross profit remaining in backlog: 2,994,254
Months of 2026 overhead covered: 10.1

Kestrel's backlog carries about $3.0 million of remaining gross profit, enough to cover about ten months of next year's overhead. That is a reasonably comfortable position, provided the estimates hold; given the history of fade, management should assume some of that gross profit will not materialize.

Capstone: Kestrel's financial health review

The review below is the kind of report a controller would prepare for the owners and share, in summary, with the surety and bank. It uses only figures developed in this course. Students should be able to reproduce every number.

Recommendations

Closing the loop with the projects

The financial health of a contractor is built on site. Revenue and profit depend on the estimates project managers make every month; cash depends on how quickly they bill and close out; bonding capacity depends on whether their jobs finish as forecast. The tools in this course, the WIP schedule, the overhead and equipment budgets, the cash forecast and the ratios, are ways of seeing the projects as a whole and acting before small problems become fatal ones. A project manager who understands them can explain to the owners, the surety and the bank not just what happened on a job, but what it means for the company.