IDENTIFYING RISKY A/E FIRMS USING RATIOS

Kenneth C. Gardiner  Partner in charge of quality control.  Provides auditing, accounting and consulting services to A/E Firms.  Specializes in FAR Overhead Rate audits and advises A/E Firms on their overhead rate calculations. CPA, CCIFP, CDA, Partner-in-charge of Assurance Services

 Dannible & McKee, LLP is a New York-based firm of Certified Public Accountants and Consultants.  Experienced working with hundreds of professional architecture, engineering, planning and environmental consulting firms across the country.  We handle financial analysis and tax planning for architecture and engineering (A/E) firms in addition to providing FAR audits, reviews, and compilations for clients who contract with dozens of Federal and state agencies nationwide.  We provide outsourced contract closeout audits and other services to the New York State Department of Transportation (NYSDOT). Who is Dannible & McKee, LLP? 3

Two Risks We Evaluate When Accepting a FAR Audit  Risk that the Firm is not financially sound, can’t complete its projects, and of course not pay for our services.  The second and more important risk, is the risk that the Firm is manipulating its overhead rate. Can be because of the first risk, if the firm is performing poorly, the higher the risk they might be manipulating their overhead rate to increase profitability. We also assess this risk through initial discussions with management. We use an initial ratio analysis to further assess these risks and to assess risk as a component of our audit planning process.

Analysis of Key Financial Ratios  Ratios are not ends in themselves but provide keen insights into the operation of a firm  Financial ratios serve as benchmarks against which the firm can evaluate itself and are only useful when: Compared with the same ratios, for the same firm, for prior periods; Compared to some predetermined standard; Compared with the same ratios for other firms in the same industry; or Compared with average ratios for the industry in which the firm operates.

Analysis of Key Financial Ratios  When we evaluate an AE Firm, we start with the balance sheet and review liquidity and leverage ratios to determine its financial strength and at a single point in time  The balance sheet shows if the Firm has enough working capital and equity to operate effectively for the near term  The income statement shows whether the firm is operating profitably currently and year to date: A/E Firms can generally correct poor performance relative quickly as 70% of total costs are labor and related costs;

Analysis of Key Financial Ratios  Financial analysts group financial ratios into categories which tell us about the different facets of a firm’s finances and operations  For design firms, this includes the following: Liquidity Ratios Leverage Ratios Operating Ratios Net Income Ratios Labor Ratios Overhead Ratios Staff Ratios

The following slides present an overview of the financial ratio categories along with formulas for the various key ratios and an illustration of the key financial ratios for D.M. Associates. 8

D.M. Associates Case Study Exhibit A – Balance Sheet

D.M. Associates Case Study Exhibit A – Balance Sheet - Continued

D.M. Associates Case Study Exhibit B – Income Statement

Liquidity Ratios  Liquidity ratios provide an indication of a firm’s short-term financial situation or solvency  These ratios provide an indication of a firm’s ability to meet its obligations which will come due within the next 12 months  Key ratios for the design industry include the Current Ratio, Working Capital, Accounts Receivable Turnover Ratio, Average Work-in-Process

Liquidity Ratios Current Ratio Without Deferred Taxes

Liquidity Ratios Current Ratio Without Deferred Taxes

Liquidity Ratios Working Capital

Liquidity Ratios Days Fees in Billed Receivables (Average Collection Period)

Liquidity Ratios Days Fees in Unbilled Work-in-Process (Average Days of Work-in-Process)

Leverage Ratios  Leverage ratios measure the extent to which a firm’s operations are financed by debt capital versus equity capital  Leverage ratios also provide an indication of a firm’s vulnerability to business downturns  Key leverage ratios for the design industry include the Debt/Equity Ratio and Bank Debt/Equity Ratio

Leverage Ratios Debt/Equity Ratio

Leverage Ratios Bank Debt/Equity Ratio

Operating Ratios  Operating ratios measure the firm’s ability to utilize its resources to generate revenue and profit; such resources includes the firm’s labor force,  Operating ratios also measure the firm’s ability to control costs in performing services  Key operating ratios for the design industry can be further categorized into Net Income Ratios, Labor Ratios, Overhead Ratios and Staff Ratios, each predicated on the key components of a properly-formatted income statement for a design firm

Operating Ratios Net Revenue per Chargeable Hour

Operating Ratios Direct Labor Cost per Chargeable Hour

Operating Ratios Contribution Margin

Operating Ratios Net Income Before Discretionary Items / Net Revenue

Operating Ratios Return on Equity (After-Tax)

Operating Ratios Return on Assets (After-Tax)

Operating Ratios – Labor Ratios Net Multiplier Achieved

Operating Ratios – Labor Ratios Net Payroll Multiplier

Operating Ratios – Labor Ratios Chargeable Ratio (Payroll Dollars)

Operating Ratios – Overhead Ratios Overhead Rate (Before Discretionaries)

Operating Ratios – Labor Classification  The misclassification of labor (between direct and indirect) can skew a firm’s ratio analysis when compared to industry norms When direct labor is classified indirect labor, the following ratios will be affected: When indirect labor is classified direct labor, the following ratios will be affected:

Job Cost Variance Account (Labor Variance Account)  Difference between actual labor costs incurred and labor costs charged on time sheets at predetermined rates entered in the software.  Negative Cost Variance (Dr) – Actual labor costs incurred are greater than hours charged on time sheets at predetermined rates.  Positive Cost Variance (Cr.) – Actual labor costs incurred are less than the hours charged on time sheets at predetermined rates.  Often this represents the hours charged in excess of 40 hrs by salaried employees at their standard cost rate. Auditors need to understand how this account works and the impact of the balance as it directly affects labor classification and the overhead rate.

Example 34 Example: Mike is a salaried employee and is paid $3,000 bi-weekly, and he has an hourly cost rate of $37.50/hour ($3,000/80 hours). When timesheets are posted, the actual hours worked are multiplied by the hourly rate. A debit is posted to the direct and/or indirect labor account and a credit to the Job Cost Variance (JCV) account. Mike’s hours are applied at a cost rate of $37.50 for every hour regardless of how many hours he works. When payroll is posted, a debit to the JCV account for Mike’s bi-weekly salary - $3,000. If Mike worked 85 hours in an 80 hour timesheet period, the JCV account would be ($187.50) (Cr) because the credit posted to JCV was $3, at the time of timesheet posting and the debit posted for payroll is $3,000. If Mike had only worked 75 hours during the timesheet period, the JCV account would be a positive $187.50(Dr)

Example 35 You have to analyze the labor variance account if significant and determine if the internal labor rates are accurate and the factors that lead to a significant variance. Firms can manipulate their direct labor charges and rates and their overhead rate by changing the standard cost rates entered in the software. When we find these conditions it clearly indicates a high risk firm. One that we are not likely to continue working with.

Resources  PSMJ Resources, Inc. PSMJ Resources, Inc. is a leading authority, publisher, and consultant on the effective management of architecture, engineering, and construction firms.  The Risk Management Association (RMA) RMA is a member-driven professional association with an objective of advancing sound risk principles in the financial services industry.  Deltek Deltek delivers enterprise software and information solutions for project- based businesses.

Contact Information Kenneth C. Gardiner CPA, CCIFP, CDA, Partner-in-charge of Assurance Services – Web – and Address Financial Plaza 221 S. Warren St. Syracuse, New York Phone –

Any tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Circular

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