Accounting Ratios in Construction

Accounting ratios are powerful tools that help construction companies analyze their
financial performance and make informed decisions. They provide a quantitative way to
understand key aspects of a company's financial health, such as liquidity, profitability,
efficiency, and leverage.

This guide will explore some of the most important accounting ratios for construction
companies, providing real-world examples in peso (₱) to illustrate their application.

1. Liquidity Ratios:

 Current Ratio: This ratio measures a company's ability to meet its short-term
obligations using its current assets.
o Formula: Current Ratio = Current Assets / Current Liabilities
o Example: ABC Construction has current assets of ₱5,000,000 and current
liabilities of ₱2,500,000. Their current ratio is 2 (₱5,000,000 / ₱2,500,000).
This indicates that they have twice as many current assets as liabilities,
suggesting strong short-term liquidity.
o Interpretation: A current ratio of 1 or higher is generally considered
healthy for construction companies. A ratio below 1 might signal potential
liquidity issues.
 Quick Ratio (Acid-Test Ratio): This is a more stringent measure of liquidity that
excludes inventory from current assets, as inventory can be difficult to convert to
cash quickly.
o Formula: Quick Ratio = (Current Assets - Inventory) / Current Liabilities
o Example: If ABC Construction's inventory is ₱1,000,000, their quick ratio
would be 1.6 ((₱5,000,000 - ₱1,000,000) / ₱2,500,000). This indicates that
they have ₱1.60 of quick assets for every ₱1 of current liabilities,
demonstrating a strong ability to meet short-term obligations even without
relying on inventory.
o Interpretation: A quick ratio of 1 or higher is generally considered good for
construction companies.
 Cash Ratio: This is the most conservative liquidity ratio, measuring a company's
ability to meet short-term obligations using only cash and cash equivalents.
o Formula: Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities
o Example: If ABC Construction has ₱1,500,000 in cash and cash equivalents,
their cash ratio would be 0.6 (₱1,500,000 / ₱2,500,000). This means they
have ₱0.60 of cash and cash equivalents for every ₱1 of current liabilities,
indicating a moderate ability to cover short-term obligations solely with cash.
o Interpretation: A higher cash ratio indicates a stronger ability to meet
short-term obligations without relying on other assets.

2. Profitability Ratios:

 Gross Profit Margin: This ratio measures how much profit a company earns from
its revenue after deducting direct production costs (labor, materials).
o Formula: Gross Profit Margin = Gross Profit / Revenue
o Example: If ABC Construction has revenue of ₱10,000,000 and a gross profit
of ₱3,000,000, their gross profit margin is 30% (₱3,000,000 / ₱10,000,000).
o Interpretation: A higher gross profit margin indicates better profitability
and a stronger ability to cover direct costs.
  Net Profit Margin: This ratio measures a company's overall profitability after
accounting for all expenses, including operating expenses, taxes, and interest
payments.
o Formula: Net Profit Margin = Net Income / Revenue
o Example: If ABC Construction has a net income of ₱1,000,000 and revenue
of ₱10,000,000, their net profit margin is 10% (₱1,000,000 / ₱10,000,000).
o Interpretation: A higher net profit margin indicates greater efficiency in
managing costs and generating profits.
 Return on Investment (ROI): This ratio evaluates the return generated from an
investment, such as a specific project or a capital expenditure.
o Formula: ROI = Net Profit / Total Investment
o Example: If ABC Construction invests ₱5,000,000 in a new project and earns
a net profit of ₱1,000,000, their ROI is 20% (₱1,000,000 / ₱5,000,000).
o Interpretation: A higher ROI indicates a more profitable investment.

3. Efficiency Ratios:

 Asset Turnover Ratio: This ratio measures how efficiently a company utilizes its
assets to generate sales.
o Formula: Asset Turnover Ratio = Revenue / Total Assets
o Example: If ABC Construction has revenue of ₱10,000,000 and total assets
of ₱5,000,000, their asset turnover ratio is 2 (₱10,000,000 / ₱5,000,000).
o Interpretation: A higher asset turnover ratio indicates better asset
utilization and efficiency in generating sales.
 Inventory Turnover Ratio: This ratio measures how quickly a company sells its
inventory.
o Formula: Inventory Turnover Ratio = Cost of Goods Sold / Average
Inventory
o Example: If ABC Construction has a cost of goods sold of ₱7,000,000 and
average inventory of ₱1,000,000, their inventory turnover ratio is 7
(₱7,000,000 / ₱1,000,000).
o Interpretation: A higher inventory turnover ratio indicates more efficient
inventory management and a faster rate of inventory sales.
 Accounts Receivable Turnover Ratio: This ratio assesses how quickly a
company collects payments from its customers.
o Formula: Accounts Receivable Turnover Ratio = Credit Sales / Average
Accounts Receivable
o Example: If ABC Construction has credit sales of ₱8,000,000 and average
accounts receivable of ₱2,000,000, their accounts receivable turnover ratio
is 4 (₱8,000,000 / ₱2,000,000).
o Interpretation: A higher accounts receivable turnover ratio indicates
efficient management of credit sales and prompt collection of payments.

4. Leverage Ratios:

 Debt-to-Equity Ratio: This ratio measures how much debt a company uses to
finance its assets and operations compared to its equity.
o Formula: Debt-to-Equity Ratio = Total Debt / Total Equity
o Example: If ABC Construction has total debt of ₱3,000,000 and total equity
of ₱2,000,000, their debt-to-equity ratio is 1.5 (₱3,000,000 / ₱2,000,000).
 o Interpretation: A higher debt-to-equity ratio indicates a higher level of
financial leverage and potentially greater risk.

5. Other Important Ratios:

 Return on Equity (ROE): This ratio measures how effectively a company uses its
shareholders' equity to generate profits.
o Formula: ROE = Net Income / Shareholders' Equity
 Return on Assets (ROA): This ratio measures how effectively a company uses its
assets to generate profits.
o Formula: ROA = Net Income / Total Assets

Horizontal and Vertical Analysis of Financial

Statements

This response will provide a detailed explanation of horizontal and vertical analysis applied to
financial statements in the construction industry, using a real-world example.
1. Introduction to Horizontal and Vertical Analysis

Horizontal Analysis, also known as Trend Analysis, compares financial data across multiple
periods to identify trends and growth patterns over time. It reveals how specific line items have
changed from one period to another, expressed as a percentage. [1]

Vertical Analysis, also known as Common-Size Analysis, analyzes the proportional

relationship between line items on a financial statement within a single reporting period. It
expresses each line item as a percentage of a relevant base figure for that statement. [1]

2. Real-World Example: Construction Company "BuildRight"

Scenario: BuildRight is a medium-sized construction company operating in the Philippines. We

will analyze its financial statements for the years 2022 and 2023 to demonstrate the application
of horizontal and vertical analysis.

Financial Statements:

 Income Statement:
o Revenue: ₱200,000,000 (2022) and ₱250,000,000 (2023)
o Cost of Goods Sold (COGS): ₱150,000,000 (2022) and ₱180,000,000 (2023)
o Gross Profit: ₱50,000,000 (2022) and ₱70,000,000 (2023)
o Operating Expenses: ₱30,000,000 (2022) and ₱35,000,000 (2023)
o Net Income: ₱20,000,000 (2022) and ₱35,000,000 (2023)
 Balance Sheet:
o Total Assets: ₱100,000,000 (2022) and ₱120,000,000 (2023)
o Total Liabilities: ₱50,000,000 (2022) and ₱60,000,000 (2023)
o Total Equity: ₱50,000,000 (2022) and ₱60,000,000 (2023)

3. Horizontal Analysis of BuildRight

Income Statement:

Percentage
Line Item 2022 (₱) 2023 (₱) Change (₱)
Change

Revenue 200,000,000 250,000,000 50,000,000 25%

COGS 150,000,000 180,000,000 30,000,000 20%

 Percentage
Line Item 2022 (₱) 2023 (₱) Change (₱)
Change

Gross Profit 50,000,000 70,000,000 20,000,000 40%

Operating Expenses 30,000,000 35,000,000 5,000,000 16.67%

Net Income 20,000,000 35,000,000 15,000,000 75%

Balance Sheet:

Line Item 2022 (₱) 2023 (₱) Change (₱) Percentage Change

Total Assets 100,000,000 120,000,000 20,000,000 20%

Total Liabilities 50,000,000 60,000,000 10,000,000 20%

Total Equity 50,000,000 60,000,000 10,000,000 20%

Interpretation:

 Revenue Growth: BuildRight experienced a significant 25% increase in revenue from

2022 to 2023, indicating strong growth in its construction business.
 Profitability: The company's gross profit and net income both increased substantially,
suggesting improved efficiency and cost management.
 Asset Expansion: The increase in total assets indicates that BuildRight invested in
additional resources, potentially expanding its operations or acquiring new equipment.
 Debt Financing: The rise in total liabilities suggests that BuildRight might have taken on
more debt to finance its growth, which could impact its financial leverage.

4. Vertical Analysis of BuildRight

Income Statement:

Percentage of Percentage of
Line Item 2022 (₱) 2023 (₱)
Revenue Revenue

200,000,00
Revenue 100% 250,000,000 100%
0
 Percentage of Percentage of
Line Item 2022 (₱) 2023 (₱)
Revenue Revenue

150,000,00
COGS 75% 180,000,000 72%
0

Gross Profit 50,000,000 25% 70,000,000 28%

Operating
30,000,000 15% 35,000,000 14%
Expenses

Net Income 20,000,000 10% 35,000,000 14%

Balance Sheet:

Percentage of Total Percentage of Total

Line Item 2022 (₱) 2023 (₱)
Assets Assets

Total Assets 100,000,000 100% 120,000,000 100%

Total
50,000,000 50% 60,000,000 50%
Liabilities

Total Equity 50,000,000 50% 60,000,000 50%

Interpretation:

 Cost Structure: COGS as a percentage of revenue decreased slightly in 2023, indicating

potential improvements in material sourcing or cost management.
 Profit Margin: BuildRight's gross profit margin and net income margin both increased,
suggesting better profitability.
 Financial Leverage: The company maintains a 50/50 ratio of debt to equity, which might
be considered a healthy balance.

5. Insights and Implications

 Growth and Profitability: BuildRight demonstrates strong growth and improved

profitability, indicating a positive trajectory.
  Cost Management: The company seems to be effectively controlling its costs, as
evidenced by the decreasing COGS percentage and increasing profit margins.
 Financial Structure: The 50/50 debt-to-equity ratio suggests a balanced financial
structure, but further analysis of specific debt types and interest expenses is needed.
 Industry Benchmarks: Comparing these results to industry averages for construction
companies in the Philippines would provide valuable context for assessing BuildRight's
performance.

Audits in Construction

1. Types of Audits in Construction

Construction audits can be broadly categorized into:

 Financial Audits: These focus on the financial statements of a construction company or

project, verifying the accuracy of revenue, expenses, assets, and liabilities. They are often
conducted by independent auditors to ensure compliance with accounting standards and
provide assurance to stakeholders like lenders, investors, and project owners. [5]
 Quality Audits: These assess the adherence to quality standards and specifications
throughout the project lifecycle. They examine the processes, materials, workmanship,
and documentation to ensure the project meets the required quality standards and client
expectations. [4]
 Safety Audits: These evaluate the safety practices and procedures on a construction
site. They focus on identifying potential hazards, assessing compliance with safety
regulations, and ensuring the well-being of workers. [1]
 Compliance Audits: These examine the project's adherence to legal and regulatory
requirements, including building codes, environmental regulations, labor laws, and
contract terms. They ensure that the project is conducted ethically and within the bounds
of the law.
 Performance Audits: These evaluate the overall effectiveness and efficiency of a
construction project or company. They analyze factors such as cost control, schedule
adherence, resource utilization, and project outcomes to identify areas for improvement.

2. Real-World Example: Bridge Construction Project

Scenario: Imagine a major bridge construction project in Manila, Philippines, undertaken by a

consortium of construction companies. The project is funded by a combination of government
and private investment.

Types of Audits Involved:

 Financial Audit: An independent accounting firm is hired to conduct a financial audit of

the consortium's financial statements. This audit ensures that the project's revenue,
expenses, and financial position are accurately reported to investors and lenders. The
audit also verifies compliance with accounting standards and tax regulations in the
Philippines.
 Quality Audit: A team of qualified engineers and construction professionals conducts
regular quality audits throughout the project. They inspect materials, review construction
methods, and assess the quality of workmanship to ensure the bridge meets the required
standards of durability, safety, and aesthetics.
 Safety Audit: A dedicated safety team conducts frequent safety audits on the
construction site. They identify potential hazards like scaffolding instability, improper use
of equipment, and unsafe working conditions. The team also ensures compliance with
 Philippine Occupational Safety and Health Standards (PSHS) and provides
recommendations for improvement.
 Compliance Audit: A legal team conducts a compliance audit to ensure the project
adheres to all relevant laws and regulations. This includes verifying permits, licenses,
environmental impact assessments, and labor contracts. They also ensure the project
complies with the terms of the government and private investment agreements.
 Performance Audit: A project management team conducts performance audits to assess
the project's progress against the planned schedule and budget. They analyze factors like
cost overruns, delays, and resource allocation to identify areas for improvement and
ensure the project is completed on time and within budget.

Benefits of Audits:

 Transparency and Accountability: Audits promote transparency and accountability

within the project, ensuring that all stakeholders are aware of the project's financial
status, quality, safety, and compliance.
 Risk Mitigation: By identifying potential problems early, audits help mitigate risks,
prevent costly errors, and ensure the project's success.
 Improved Efficiency: Audits can identify areas for improvement in processes, resource
utilization, and cost control, leading to increased efficiency and reduced project costs.
 Compliance with Regulations: Audits ensure compliance with relevant laws,
regulations, and industry standards, minimizing legal and regulatory risks.
 Enhanced Stakeholder Confidence: Regular audits build confidence among
stakeholders,

General Financial Control Over the Business

Construction accounting is a specialized field that requires a strong focus on financial control to
ensure the success and sustainability of a construction business. This response will delve into the
key aspects of general financial control in construction accounting, highlighting best practices
and strategies for effective management.

1. Importance of Financial Control in Construction

Construction businesses face unique challenges that necessitate robust financial control:

 Project-Based Nature: Construction projects are often complex, involve multiple

stakeholders, and have long timelines. This requires meticulous cost tracking, budget
management, and revenue recognition to ensure profitability. [1]
 Fluctuating Costs: Material prices, labor costs, and equipment rentals can fluctuate
significantly, impacting project budgets and profitability. Effective financial control helps
mitigate these risks. [1]
 Cash Flow Management: Construction projects often have delayed payments, creating
challenges in managing cash flow. Strong financial control is essential for maintaining
liquidity and covering operating expenses. [2]
 Compliance with Regulations: The construction industry is subject to numerous
regulations, including tax laws, labor laws, and environmental regulations. Financial
control helps ensure compliance and minimize legal risks. [3]

2. Key Elements of Financial Control in Construction Accounting

Effective financial control in construction accounting involves:

 Job Costing: This is the cornerstone of construction accounting, where costs are
meticulously tracked and allocated to specific projects. Accurate job costing provides
 insights into project profitability, identifies cost overruns, and helps make informed
decisions about bidding and pricing. [2]
 Revenue Recognition: Construction projects often span multiple accounting periods,
requiring careful revenue recognition methods. The percentage of completion method is
commonly used, where revenue is recognized proportionally as work progresses. This
ensures accurate reporting of income and expenses over the project's lifecycle. [2]
 Budget Management: Developing and adhering to detailed budgets is crucial for
controlling costs and ensuring project profitability. Regular budget reviews, variance
analysis, and corrective actions are essential for staying on track. [4]
 Cash Flow Forecasting: Predicting cash inflows and outflows is vital for managing
liquidity and avoiding financial distress. Cash flow forecasting helps identify potential
shortfalls, plan for financing needs, and optimize working capital. [5]
 Internal Controls: Establishing strong internal controls helps prevent errors, fraud, and
unauthorized transactions. This includes segregation of duties, authorization procedures,
and regular reconciliations of bank statements and accounting records. [1]
 Financial Reporting: Regular and accurate financial reports are crucial for making
informed decisions, monitoring performance, and communicating with stakeholders. These
reports should include income statements, balance sheets, cash flow statements, and key
performance indicators (KPIs). [4]

3. Best Practices for Financial Control in Construction Accounting

 Use Specialized Accounting Software: Construction-specific accounting software

streamlines financial processes, automates tasks, and provides real-time insights into
project costs and financial performance. [5]
 Implement a Cost-Coding System: Assign unique codes to each cost category (labor,
materials, equipment, etc.) to track expenses accurately and generate detailed financial
reports. [1]
 Reconcile Accounts Regularly: Compare bank statements with accounting records to
identify discrepancies, prevent fraud, and ensure the accuracy of financial information. [1]
 Track Construction Project Costs in Real Time: Monitor costs closely to identify
potential overruns and make necessary adjustments to stay within budget. [1]
 Prepare Accurate and Timely Progress Billings: Ensure timely invoicing to maintain a
steady cash flow and avoid delays in payment. [1]
 Maintain Detailed Records and Documentation: Keep thorough records of contracts,
change orders, invoices, and receipts to support financial transactions and facilitate
audits. [1]
 Review Financial Reports Regularly: Analyze financial statements to identify cost
trends, assess project profitability, and make informed decisions to optimize
operations. [1]
 Stay Updated on Industry Accounting Standards and Regulations: Keep abreast of
changes in accounting practices and regulations to ensure compliance and maintain best
practices. [1]