How To Read Your Financials
Monday, July 30th, 2007
Your reports and schedules, when understood and responded to, are precious to keeping your profit. They represent the financial control of your business. You need to use your balance sheet, income statement, working capital schedule and your schedule of estimated cost to complete jobs in progress as a sanity check against your field review, office feedback, job cost reports, project notes and other weekly and monthly schedules.
By understanding how to effectively manage from our financial and job cost information, we permanently increased our gross profits by 20 points and increased our sales by another 20%.
The problem for many smaller and mid-market companies in the construction industry is that they are often misunderstood or ignored because their reports and schedules are not trusted to be accurate. They are often not accurate 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 complete enough information for you to control your business.
Let’s go backwards. Let me explain the purpose and value of a “Balance Sheet” and an “Income Statement”.
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 stated “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 needs to state 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.
For the income statement to be correct, the balance sheet must be correct at the start and end date of the period covered by the income statement. 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.
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!
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 “lose” that many records ever, 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 12 months as a result of the revenue generated from his high-end NYC 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 and how to identify who his customers should be. He needed to know if his bid margins allowed for profit after general conditions and overhead, plus he was unsure as to whether he was making money or losing it. In addition, he was unsure about what happened to his business over the last 3 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 I sat down with my client and created a balance sheet. That involved me interviewing him to determine what he owned and owed, locating his 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, finally, the estimated costs of those jobs to complete. With that information I was able to create a balance sheet that covered the beginning of his fiscal year 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, added back in the dividends which were checks other than payroll or expense reimbursement to himself during that period. Then we looked at the payroll records to compute what he was able to earn in salary during that same eleven month period. Our final step was to combine what the client earned in salary and profit for the eleven months reviewed. The combined information noted above allowed us the basis to know, within a quick couple of hours, 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 because they will not be accurate and will likely be useless.
Next, let’s explore your estimated cost to complete/completed contracts. It is my experience that, with other than the residential developer/builders who use the “completed contracts” method of accounting for revenue and cost, nearly all contractors use the “percentage of completion” method of recognizing revenue and cost. “Completed contracts,” means just that: when the job is completely done, you “book” or record the total income and the total expense of construction on the 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 a liability called “customer deposits”, “deferred revenue”, or an item of “debt”.
Keep in mind that “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 something like “costs in excess of billings” – meaning that you have costs that you have not or can not 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, or 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 aren’t approved or won’t be approved. All jobs with costs in excess of billings will be lumped together under a liability account on the current asset side of the balance sheet. Always review it to ensure that it does not hold surprises of 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. If your “billings in excess of cost” are always substantially higher than your “costs in excess of billings”, it is good for current cash flow as long as that difference is rising. I will warn you that it will give you a false sense of cash security as once the job comes to an end because the cash flow becomes more negative. The excess billings over costs are not profit, they are simply a positive cash flow timing difference that will change from time to time.
The “schedule” of closed jobs and the open jobs “estimated costs to complete” should be prepared more often than once at year end when the accountants request it. That is a way to maintain a current review of all jobs status. That method also allows for problems to be addressed while the job is ongoing and you know you will have problems to face during the course of the project. Do not wait to address them until the job close out meeting occurs when everyone hopes they’ll do better next time rather than confronting problem situations earlier in the project. Reviewing the schedules and reports allows estimating, on superior jobs, an opportunity to bid higher or correct a problem in the bid process. It is critical to remodeling companies, as most of their problems occur during the preconstruction process, specifically in estimating errors or “buy out” of material errors.
Our firm instituted a weekly job review and estimated cost to complete process for one of our remodeling company clients, Xylem Builders, Inc.. Margins on their jobs increased by twenty points as a result of their being able to identify problems immediately and making corrections in preconstruction in the future. Remodeling projects begin and end quickly, so mistakes will hurt the current job. Those mistakes do not have to be repeated if you institute weekly reviews and estimates. It can be difficult and time consuming to correctly prepare an estimated “cost to complete schedule” for larger jobs in their early stages, yet it is worthwhile. You may continue to assume that your estimate is correct. However, the estimator, project manager, job superintendent and controller must review a job early on to determine what is needed to complete and uncover looming problems. That step will create better value engineering, change orders will be billed in a timely manner and job profit will increase. Each of these steps were taken by our client, margins increased over 20 points on average within 2 months, and sales have continued to increase by over 20%. They made less mistakes, sold more jobs, and controlled the margins that were sold consistently by adding on this process routinely with the sales person, estimator, and field superintendent.
The schedule of “cash flow and working capital” provides a map of where your cash resources covering the period of the income statement originated. It consists of profit, new loans or repayment (principle due more than twelve months in the future), purchases or sales of capital assets and depreciation. All of these have the affect of increasing or decreasing cash. An accurate reading of the schedule results in better billing practices, better collection practices and prevents slower paying of vendors and subs. It shows where and how money was used to absorb losses, the debt principle repayments and may contribute to faster paying of bills. It prevents poor billing practices, slow receivables and reflects retainage receivables, purchase of equipment or other assets. If the opening and closing period balance sheets are correct, then this schedule will be correct. I repeat, “If the balance sheets are not correct, do not waste your time looking at this schedule… or any other financial statement…because they will be wrong!”
Working capital is defined as the total of your “current assets” which is comprised of your cash, receivables, retainages, costs in excess of billings, work in progress, inventories and prepaid expenses minus your “current liabilities”. Your current liabilities are comprised of your lines of credit, principle payments of debt due within twelve months, accounts payable, accrued expenses, payroll, and taxes, billings in excess of costs, customer deposits and deferred income. A greater than 1:1 ratio is important. Your bank may require a defined working capital ratio, so check your loan documents. If the ratio is too high, you’re likely wasting the use of your cash and resources by making them too idle. A good business analyst will determine the amount of your excess working capital/cash that is funding the income statement profit versus your normal operations. I have seen many a multi-generational businesses with excessive working capital and upon a quick analysis of a profitable income statement, saw a story portraying a generous financial income but it was derived from discounts from vendor early pay, interest income and low interest expense. In fact, it was a poor business operation masked by the working capital wealth of the company.
Your income statement should be a validation of what you believe is going on with your jobs in the field, assuming that your opening and closing balance sheets are correct. Your income statement should be in the same category as your job cost comparison to your estimates; and it should be in a format that allows you to, at a glance, see the critical components of your business and whether they are operating according to plan or poorly. In order for your income statement to be used as the effective management tool and “sanity check” that it was meant to be, the following components must exist for a construction company:
It must be an accrual, not cash basis statement. Accrual means you have recorded all your receivables and debt inclusive of payables on the balance sheet.
- It must include not only numbers next to the expense categories, but percentages of revenue next to the number.
- The only revenue in your top line should be job revenue. No interest income, rebates, sales of equipment should be included.
- The costs of construction must be detailed to identify construction labor and payroll added costs, subcontractors, materials, equipment rentals, revenue driven liability insurance, superintendents’ costs or other direct costs of construction as detailed in the estimate and tracked in your job cost reports. Some or all of these are your “Direct Job Costs”. Labor, materials, subs, and equipment rental, permits, direct insurance, etc. are at a minimum, included here, on your job cost reports regardless of software, and in the estimate.
- Indirect construction costs such as mobilization, trucks, pagers, cell phones, supers, trailers, etc. may be what you call “general conditions”. Define what you mean by “general conditions” and categorize these costs separately on your income statement. This will allow you to see if the general conditions you are utilizing in your estimates are making you money or losing you money.
- Categorize your pre-construction costs of estimators and bidding / selling expenses separately on the income statement. Divide the number of bids or estimates produced into this total and see what it is costing you to bid. Add that to your bid to award ratio and you may find not only that you’re wasting money in bids you’ll never get but how much you are wasting.
- Keep the office and support staff under an administrative expense category. Be sure to allocate the workmen’s compensation insurance, vehicle and equipment insurance, depreciation, payroll taxes, benefits, safety, and training to the indirect or general conditions as appropriate.
- Show purchase discounts and interest income as “Other Income” after computing profit or loss from the construction operations. These are financial incomes which are earned due to ownership, equity, and working capital, not from operations.
- Compare the percentage of gross profit from jobs completed, jobs in progress, to your income statement. This should be done before general conditions are deducted when you compare the percentage of gross profit. Be aware of additional profit that you may earn in gross profit from the labor rate that you use in estimating, versus your labor rate posted to job cost sheets or categorized on your income statement. If you use your own equipment in construction in lieu of renting it, separately analyze these costs to see if you are making or losing money in this regard. If you are earning a profit from this, that’s great, but it will likely distort the gross profit from construction if your estimate utilized a fair market rental rate.
Meet with your outside accountants if they are construction knowledgeable, or your construction business advisor, and/or your controller on a monthly basis to review your balance sheet, income statement, working capital and source and use of funds statement, and completed jobs/estimated costs to complete schedules, and do it regularly. It establishes control in your business. It also helps create the “sanity” of profit, helps avoid the “insanity” of making the same mistakes over and over again, and avoids your losing profit or your construction business itself.
The Burruano Group has just become a Bronze Sponsor to 
Ed Sundberg and Tony Burruano, Joint Managing Directors of the Burruano Group, Inc., will be delivering 2 workshops at the Southeast Building Conference (SEBC), in Orlando, Florida tomorrow, July 14 2007. Sundberg will be presenting a workshop from 8am-10am on successful succession planning (Succession Planning: What, When, Why, & How) for privately held and family owned businesses.
Two of our recent clients, one construction company with over $100 million in revenue and exceptional personnel, training, and controls in force, and another with under $2 million in revenue without any controls, had the same problem that so many of our clients face…lost profits from lack of controls of material deliveries in the field.
