Most contractors start their businesses with little knowledge of finance. Fortunately, this knowledge deficit can easily be overcome and turned into an asset. Moreover, it must be overcome. Driving a business without understanding the numbers is like driving a car, fast, in heavy fog. It is not a good idea. There are three financial statements contractors need to understand. They are the income statement, balance sheet, and cash flow statement.
Income Statement
The income statement reflects the flow of money through the company over a period of time, such as a month, quarter, or year. Sometimes this is referred to as the profit and loss statement, or P&L. The formula is simple. There are two parts. In the first part, sales minus direct costs equals gross profit.
The income statement reflects the flow of money through the company over a period of time, such as a month, quarter, or year.
Direct costs or “costs of sales” are the costs that only occur when a sale is made and are directly related to the sale. This includes parts, equipment, labor, other material, and fees related to the job, like permits.
Gross profit is a dollar amount. Gross margin is a ratio, which is gross profit divided by sales.
In the second part of the income statement, gross profit minus overhead equals net profit. Overhead is fixed expenses or expenses the business must pay whether anything is sold, or not.
Net profit, like gross profit is a dollar amount. Net profit margin is a ratio, which is net profit divided by sales. This is also called return on sales.
If your business is not profitable, either your overhead is too high or your gross profit is too low
If your business is not profitable, either your overhead is too high or your gross profit is too low. If you determine that your gross profit is too low, ask why. If the gross margin is acceptable, then your prices are too low or your direct costs are too high. If direct costs are too high, ask why.
Balance Sheet
The balance sheet is a snapshot of the financial condition of the business at a given point in time. It is also a formula. The formula is assets equal liabilities plus owner’s equity. Assets are the things of value the business owns, such as cash, inventory, tools, trucks, and so on. Liabilities are what the company owes, such as rent, truck payments, payroll, unpaid taxes, and so on.Owner’s equity is the theoretical value of the company if all assets were sold and all liabilities settled. Sometimes owner’s equity is called book value. It is positive when assets exceed liabilities and negative when they do not. It is the variable that ensures the formula will always balance. Assets must always equal liabilities plus owner’s equity. Thus, the formula could also be stated as assets minus liabilities equal owner’s equity.
Owner’s equity is the theoretical value of the company if all assets were sold and all liabilities settled
The balance sheet breaks things down another level, which is current versus long term. Current assets consist of cash and other assets that can be turned into cash within a year, like inventory. Current liabilities are required payments due within a year. Examining current assets in light of current liabilities reveals a company’s ability to sustain operations over the near term.
Dividing overhead by gross margin shows a company’s sales break-even point. This is the level of sales needed to cover fixed costs.
Cash versus Accrual
Your accounting can be on a cash basis or an accrual basis. If a cash basis is used, revenue is recognized when the cash hits the business and expenses are recognized when they are paid. By contrast, an accrual approach recognizes both when they occur, whether the money has been received/paid, or not.Sell a job where you take a couple of thousand as a down payment and the down payment is immediately recognized on a cash basis. The rest of the job is recognized when the money is received. On an accrual basis, the entire job is recognized at the time the work is performed whether the cash has been received, or not. Until the cash is received, the sale price of the job is an account receivable. Accrual accounting gives you a better picture of a company’s financial condition.
Cash Flow Statement
If the business uses accrual accounting, a cash flow statement is necessary because the cash position of a business may differ from the accrual results. A cash flow statement is also a formula.The formula is: beginning cash+ cash inflows - cash outflows = ending cash.
Cash inflows include cash from operations, from investments, and from loans.
EBITDA
You might hear the term, EBITDA. This is earnings before interest, taxes, depreciation, and amortization. It reflects the income from business operations.Diving Deeper
The three key financial statements every business owner should be familiar with are the income statement, balance sheet, and cash flow statement. Obviously, this is a very simplified description of these financial statements, but the fundamentals hold. To learn these in depth, take classes in finance. Join a contractor alliance where finance is taught in depth.For more information about the business of contracting, visit www.ServiceRoundtable.com. Join for only $50 a month. Quit at any time. Contractors serious about success should consider the Service Nation Alliance, a leading contractor best practices group. Both the Service Roundtable and Service Nation Alliance are products of Service Nation. Call 877.262.3341 for more information on either groups.