How to Read Your Financials
Many smaller and mid-market companies in the construction industry find that critical information is misunderstood or ignored because their reports and schedules are inaccurate, often because the reports are used primarily as a tool for the accountant to prepare a tax return or to fulfill a bank-reporting obligation, so they do not contain enough information for you to control your business.
But your reports and schedules, when organized, will inevitably help your profits. They represent the “financial control” of your business. It is imperative to understand how to read your financials.
A Balance Sheet
In simple terms, a balance sheet is a snapshot of the assets and liabilities of your company in a particular moment in time. It shows where you stand with what you own and what you owe on a particular date. Your assets are listed “at cost” minus any depreciation or amortization taken over the ownership period of the asset; nothing is shown at fair market value. Your balance sheet should list the amount of money the stockholders will receive before capital gains taxes on liquidation, plus or minus the fair market value of the assets versus the value stated on the balance sheet, (or the “short fall” if there is a negative equity).
The purpose of the balance sheet is to control the accuracy of the income statement. If your balance sheet is substantially inaccurate on the opening or ending date of the income statement period, then the income statement will be substantially wrong. For example, the income statement for the year ending 12-31-06 would need an accurate balance sheet dated 12-31-05 and 12-31-06.
I met with a new client recently whose accountant not only lost his records for the past three years, but could not locate his records for the current year. Knowing that accountants do not ever lose that many records and knowing that accountants normally back up their computer records, I knew we had a big problem. My client thought he had generated about $6 million in revenue from the past twelve months as a result of the revenue generated from his high-end New York City co-op remodeling projects. He had pretty good job cost and billing data but needed bank financing. He had a horrible bid-to-award ratio, and he needed guidance with his plan of revenue and profit for his company.
He needed to know:
• What his margins should be in order to win bids
• How to identify who his customers should be
• If his bid margins allowed for profit after general conditions and overhead
• Whether he was making money or losing it
• What had happened to his business over the last three years
My client and I were in a situation where we could not wait for his new accountant to slowly reconstruct his last three years of records, so we sat down and created a balance sheet. I interviewed him to determine what he owned and owed, located records which included his bank statements; accounts receivables; retainages receivables; an inventory of his trucks and computers; his vendor and subcontractor payables; the amount of debt on his trucks, cars and equipment; the jobs he had in progress; and the estimated costs of those jobs to complete. With that information, I created a balance sheet that covered the beginning and the eleventh month of his fiscal year.
Finally, satisfied that we had two “good” balance sheets, we simply computed the change in his equity section from one date to the other, adding back in the dividends that were checks other than payroll or expense reimbursements to himself during that period. Then, we looked at the payroll records to compute what he earned in salary during that same eleven month period. Our final step was to combine what he earned in salary and profit for the eleven months reviewed. The combined information, within a quick couple of hours, gave us the amount the client had earned. So, when you are unsure of your financial situation, use this short-cut to make sure your balance sheet is correct. Otherwise, look no further at your financials; they will likely be inaccurate and useless.
Estimated Cost to Complete Jobs/Projects
It is my experience that nearly all contractors use the “percentage of completion” method of recognizing revenue and cost other than the residential developer/builders who use the “completed contracts” method of accounting for revenue and cost. “Completed contracts” means just that: When the job is completely done, you “book” or record the total income and expense of construction on the Home remodel South Shore MA income statement. No income, job expense, profit or loss related to the specific job is to be recorded on the income statement until the home settles. Prior to that, the job costs appear as an item on the balance sheet named “work-in-progress.” Revenue appears as customer deposits, deferred revenue or an item of debt.
“Percentage of completion” means that revenue is recognized as income at the rate the job is completed. Job costs are recognized at the rate they are incurred in ratio to both revenue recognized and total job costs expended to date, plus what is estimated to be incurred to complete the job. Your balance sheet will have an asset entitled “costs in excess of billings,” meaning that you have costs you have not or cannot bill right now to the customer on jobs in progress. A liability account, or “billings in excess of costs” means that the contractor has billed the customer for work not yet done – which is where all contractors would prefer to be-placing the contractor ahead of the customer on a cash flow basis.
If the costs in excess of billings are greater than the billing in excess of costs, you will likely have a cash flow problem. This means that either you are spending faster than you are billing, your project managers are behind in getting their bills out, or you have costs on your balance sheet that are really losses such as job overruns or change orders that are not or will not be approved. All jobs with costs in excess of billings should be lumped together under a liability account on the current asset side of the balance sheet. Always double-check for losses not yet recorded. You, as an owner, may not know about the losses. A project manager might simply fall behind in billing, which costs you interest expense, poor vendor relationships, cash heartache and sleepless nights.