There are three financial statements contractors need to understand to improve the business-side of their company – the income statement, balance sheet, and cash flow statement.
Many contractors start their businesses without much knowledge of finance. Driving a business forward without understanding the numbers behind the business is like driving a car fast in heavy fog.
The income statement reflects the flow of money through the company over a period of time – a month, quarter, or year. The income statement is sometimes referred to as the profit and loss statement (P&L). This statement is simple because there are only two parts – sales minus direct costs equals gross profit.
Direct costs or “costs of sales” are the costs that occur when a sale is made and are directly related to that sale. Think parts, equipment, labor, other material, and fees related to the job, like permits. Gross profit is a dollar amount and gross margin is a ratio – 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. Think warehouse rental fees, employee salaries, van payments, etc.
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 your return on sales.
If your business isn’t profitable, there are one of two things happening – either your overhead is too high or your gross profit is too low. If you determine that your gross profit is too low, ask yourself 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, find out why.
The balance sheet is a snapshot of the financial condition of the business at any given point in time. The formula for the balance sheet is assets equal liabilities plus owner’s equity. Assets are the things of value the business owns – cash, inventory, tools, trucks, etc. Liabilities are what the company owes, such as rent, truck payments, payroll, unpaid taxes, and so on.
Owner’s equity is the value of the company if all assets were sold and all liabilities settled. Sometimes owner’s equity is also referred to as 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.
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.
Your accounting can be on a cash basis or an accrual basis. In cash basis, 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.
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 a formula – beginning cash + cash inflows – cash outflows = ending cash. Cash inflows include cash from operations, from investments, and from loans.
You might hear the term, EBITDA. This is earnings before interest, taxes, depreciation, and amortization. It reflects the income from business operations.
This is a very simplified description of these financial statements, but the fundamentals hold. To learn these in depth, take classes in finance or join a contractor alliance where finance is taught in depth.