The analysis of key individual financial ratios are considered the primary data source for evaluating the financial health of the contractor. The guidance states the ratios need to be "used with care" where general rules of thumb should be avoided. Rather, the contractor’s ratios should be compared with ratios found in the "applicable average industry ratios". Ideally the ratio analysis of the contractor and industry should cover three to five years of comparable data. For companies not publicly traded, the source of data should be the contractor’s financial statements – Balance Sheet, Statement of Income and Statement of Cash Flows. The source of data for publicly traded companies as well as average industry ratios are maintained by DCAA at its Technical Support Branch.

At a minimum, the following key ratios are to be calculated and monitored:

Current Ratio (Current Assets/Current Liabilities). This ratio is used to measure a company's ability to pay its short term liabilities from its short term assets.

Acid Test or Quick Ratio (Liquid Assets/Current Liabilities). This measures a company’s ability to pay off its short term obligations from assets that are readily convertible to cash.

Return on Investment – ROI (Net Income/Total Assets). This measures economic performance and is used as an indicator of management effectiveness and ability to earn a satisfactory return.

Debt to Equity Ratio (Total Debt/Stockholders Equity). Measures the relative size of creditors’ claims compared to claims of owners.

Working Capital (Current Assets-Current Liability/Total Assets). The ratio of net liquid assets to total capitalization. Consistent losses will shrink current assets in relation to total assets.

Cash Flow to Debt (Cash Flow: Net Income +Depreciation +Depletion + Amortization/Total Debt). This is an indicator of available funds to satisfy debt obligations and is considered by many to be the best indicator of financial distress.

Cash Flow Return on Assets (Cash from Operations/Total Assets). Measures cash generated from operations as opposed to income.

Cash Flow to Sales (Cash from Operations/Sales). Shows the percentage of each sales dollar realized as cash.

Cash Flow Adequacy (Cash from Operations/Long term debt + Purchases of Assets + Dividends Paid). This measures ability to generate cash sufficient to cover cash requirements to pay debt, reinvest in operations and make distributions to owners.

Debt Coverage (Total Debt/Cash from Operations). Measures how many years it will take to retire all debt at current level of cash from operations.

The auditor is told to ask the contractor if there are other financial ratios that should be considered when evaluating their financial condition. The purpose of monitoring the ratios is based on the concept that as businesses deteriorate so do the key ratios. Similarly, comparison to industry averages provides another indicator of financial problems. When a contractor is experiencing a negative trend and it is worse than the industry average, red flags are raised requiring the auditor to perform a financial capability audit. (Editor’s Note. If certain financial ratios appear to be unsatisfactory, auditors may need to be reminded that especially privately owned companies engage in perfectly acceptable financial practices that may affect financial ratios. For example, one company may decide to take out most of its wealth from the company and then lease assets to it while others may decide to keep most wealth in the company to minimize taxes. Such perfectly rationale actions can adversely affect certain financial ratios. We address how rational financial decisions made by smaller companies differ from standard business practices in an article in the first quarter 2003 issue –Vol 6, NO.1 - of the DIGEST.)

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