Legendary NFL head coach Bill Parcells famously said, “you are what your record says you are.” Numbers don’t lie, and results often speak for themselves. As a construction contractor, you should know what your record is.
But where can you find your record? No, it’s not the number of bids you’ve won or the amount of revenue you’re bringing in. To know what your record is you must turn to financial statements.
Financial statements are written records that provide a comprehensive view of all business activities and financial performance. This information is invaluable for both you and any interested third parties, such as accountants, potential investors, or the government.
Financial statements are reflected in three distinct forms:
In this article, we will focus on the three most important financial statements: income statements, balance sheets, and cash flow statements. By understanding these statements, contractors can make informed decisions, identify strengths and weaknesses, avoid potential problems, and effectively communicate with stakeholders, all of which contribute to the success of your business.
Before we dive, it’s worth having a deeper discussion on the importance of financial statements. First, financial statements (i.e., balance sheets, income statements, cash flow statements) provide an accurate snapshot of financial health and insight into future trends.
For example, does your income statement show that costs are continuing to rise? Are increasing costs starting to affect profitability? This could be a sign that you’re struggling to manage costs as you scale your business, or it could reveal problems with operational efficiency.
Identifying these trends is crucial for understanding where you stand financially. But it’s not all about just confronting the negatives of your business. In reality, the opposite is true. Identifying these pain points in your financial operations will reveal areas of potential improvement.
Consistent financial reporting and routine analysis of your financial statements is a necessary part of the job—regular review and adjustments made off of statements bring the following benefits:
If you’re a contractor who is spending nights worrying about the future of your business, financial statements can hold the answers that you seek. Gathering and analyzing financial statements will allow you to make adjustments or investments to help grow your business or improve profitability or cash flow issues.
Analyzing and interpreting your financial statements is an art form of its own that takes practice and experience. However, with a little bit of know-how and a drive to make your business better, you can use your financial statements to make very real improvements to your business for long-term and sustained growth.
Below, we’ll break down each of the three major accounting documents that make up the core of your financial statements.
The income statement, also known as a profit and loss statement (P&L), will tell you how much money you earned during a set period of time. On a high level, this report will tell you if you made money or lost money over a specific time period.
Typically, accountants will generate an income statement for each three-month period within a fiscal year and for each full year. Income statements will always come with a label that reflects the specific time period–(e.g., January 1, 2023 to December 31, 2023). It’s important to always know the reporting period for which an income statement reflects. Timeframes matter; don’t overlook this detail.
Income statements have three basic components:
Income statements provide crucial pieces of information that you can use to determine margins, return equity, and your overall consistency in earnings. A thorough analysis of the income statement will reveal your business’s ability to protect long-term profits. Investors or financiers will often go directly to an income statement. It’s a first impression of your financial standing that says a lot about your long-term growth potential.
Under the accrual basis of accounting, the income statement displays all your revenues, costs, and expenses for a particular period. While providing a convenient summary, you should be aware that your income statement won’t show you how much your bank balance has increased or decreased in a given period of time. It’s crucial to understand that cash flow can be impacted by items not captured within the income statement.
The first line on an income statement will reflect total (gross) revenue. This simply displays the amount of money earned from jobs that came in during a specific period of time. For example, if you earned $1 million from performing jobs in a single year, you’ll report $1 million in revenue for the year on your yearly income statement.
Put very simplistically, an income statement reports revenues, but it’s important to note that revenue does not always translate to profit. Just because you’re bringing in a lot of money doesn’t mean it all ends up in your bank account at the end of the day.
Total revenue by itself really doesn’t tell you much and shouldn’t be used as an effective gauge of your financial standing. To determine profit you must subtract total expenses from your total revenue to arrive at net earnings.
Right under total revenue, you’ll find Cost of Goods Sold (COGS). Also known as Cost of revenue, COGS are expenses that went directly into projects or materials that you sold (materials, direct labor costs, etc.).
In construction, cost of goods sold will most likely be your major job costs (i.e., labor costs, material costs, equipment costs, and subcontractor fees).
COGS subtracted from total revenue will show your gross margin.
| Income Statement (Jan 1 – March 31) | |
|---|---|
| Revenue | $100,000 |
| Cost of Goods Sold | $70,000 |
| Gross Profit | $30,000 |
From the example above gross profit for this period is equal to $30,000. This is the amount of revenue left over after subtracting major jobs costs. Gross profit does not include indirect costs like admin expenses, advertising or sales expenses, or overhead costs. Gross profit drives your ability to spend everywhere else as it represents money that is actually yours to spend.
With your gross profit you can use the following formula to find your gross profit margin:
Gross profit margin is one of the most important numbers you can know about your business. If you were to only know and check one number on a regular basis, it should be this one. You should set a recurring goal to improve your gross profit margin.
Understanding your job costs and how those costs are affecting your bottom line through gross profit margin, is a tried and true way to measure the efficiency of your jobs, overall business operations, and even the effectiveness of your sales and bidding process. Contractors that have consistently high or increasing gross profit margins are likely to have a strong financial future that will endure over the long-term.
The construction industry is highly competitive and gross profit margins are often razor thin. This is all the more reason to pay close attention to knowing and improving this number. Companies with a gross profit margin of 40% or higher are considered to have a competitive advantage with a strong financial standing.
However, the average gross profit margin for construction companies is around 20%, indicating how fiercely competitive the specialty trades can be. Small adjustments have big impacts in this type of environment. Improving efficiency, controlling job costs, and simplifying business processes can make all the difference.
Operating expenses will include all costs needed to keep your operations up and running. This includes rent, marketing or advertising costs, payroll, insurance costs, and any additional administrative costs. In short, these are all non-COGS costs.
From operating expenses, you can calculate EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization). EBITDA is a measure of your financial health across projects, which shows the amount of money that is available to be used for reinvestment or to settle outstanding debts.
With that said, EBITDA can be deceiving. It’s more akin to a poor man’s cash flow statement. It shouldn’t be solely relied on for making financial evaluations as it’s not a true representation of cash flow.
This line item in the income statement is where you’ll report all costs related to selling in addition to administrative expenses generated during a given time period.
These costs include the following:
While the major job costs should always take priority, if left unchecked, SG&A costs can eat into your gross profit margins. Typically, the lower your SG&A costs are, the better.
These are expenses incurred when a company takes ownership of physical resources such as equipment or buildings. Depreciation refers to the decrease in value over time of physical assets, while amortization is the process of spreading the costs of an intangible asset over its useful life.
For example, a company purchases a building for $900,000 that depreciates over a period of 30 years at a rate of $30,000 a year.
Interest expense is the amount of money paid out on any debt you carry on your balance sheet as a liability. This type of cost is not directly related to performing jobs. Simply put, this is the cost of borrowing money and reflects the total debt you’re carrying. The more debt you’re carrying, the more you’ll have to pay in interest.
Interest is typically expressed as a percent and is based on the current market rate. For example, a 4% interest rate means that the borrower pays 4 cents for each dollar borrowed. The percentage of interest will vary from industry to industry and from trade to trade. However, it’s best to keep this percentage as low as possible, especially if you’re trying to appeal to investors.
This line item reflects income after all expenses have been factored in, but income tax is still yet to be subtracted. To calculate this, subtract operating expenses and interest from a company’s total revenues.
You must pay taxes on any income earned. In the United States, the current rate is 35% of income. When you pay these taxes you’ll record them under the Income taxes paid line item in your income statement.
Net earnings reflect the amount of money you’ve made after subtracting all expenses and taxes.
This is the amount of revenue left over after taxes, administrative expenses, and other operating expenses have been subtracted from total revenue. If total expenses exceed total revenue, the result is a net loss.
Net earnings of the company on a per-share basis for a specific time period. This is a company’s net income divided by the number of common shares outstanding. It is used to determine how much money each shareholder stands to earn.
For example, if a company has $1 million of net income and 10 million common shares outstanding, the earning per share is $0.10. This number is subsequently high up on the priority list for those looking to invest in your company. Investors will reference this number to determine if your business is on a long-term upward trend with consistent earnings.
A balance sheet report will show the liquidity of your business at any given time. In other words, a balance sheet will show you how much you have in assets (e.g., cash or property) and how much you owe to banks or vendors.
Balance sheets differ from income statements in that they only capture a moment in time. Meaning there is no such thing as a balance sheet for the year. Instead, your accountant will generate a balance sheet at the end of each quarter, and on whatever day that happens to be (i.e., March 31 or September 30), the balance sheet will show you a snapshot of your financials for that specific day.
A balance sheet is broken down into three components:
Example of Assets on a balance sheet:
| Balance Sheet / Assets | |
|---|---|
| Cash & Short-Term Investments | $350,000 |
| Total Inventory | $100,000 |
| Total Receivables, Net | $150,000 |
| Prepaid Expenses | $65,000 |
| Other Current Assets, Total | $0 |
| Total Current Assets | $665,000 |
An asset is any resource that you own or control that holds economic value. Assets can be either tangible (physical things like equipment) or intangible (non-physical things like trade secrets or patents). Traditionally, assets are further broken down into two types: Current Assets and All Other Assets.
Current Assets will reflect cash, cash equivalents, short-term investments, and net receivables. Essentially, Current Assets are the amount of cash you have on hand or assets that can be quickly converted into cash–quickly is defined as under a year. These assets are vital to your business because of their ability to turn into cash for immediate spending to keep day-to-day operations running should the need arise.
All other assets are defined as any assets that you cannot quickly convert into cash within a year. This includes long-term investments, certain types of equipment, properties, accumulated amortization, and any other intangible assets.
In the construction industry, assets are often physical items such as equipment, tools, and various materials necessary to perform jobs or services.
Example of liabilities on a balance sheet:
| Balance Sheet / Liabilities | |
|---|---|
| Accounts Payable | $138,000 |
| Accrued Expenses | $50,500 |
| Short-Term Debt | $60,000 |
| Long-Term Debt Due | $13,000 |
| Other Current Liabilities | $5,000 |
| Total Current Liabilities | $266,500 |
Opposite assets, liabilities reflect any legal responsibility that you have to pay debts or fulfill contractual obligations. Examples include loans, accounts payable, bonds, or deferred revenues. In a construction setting, liabilities will often come in the form of accrued labor costs, customer deposits, and accounts payable owed for materials.
Listed first under liabilities is Accounts Payable, or A/P, which describes money owed by one company to another for invoices that have been properly presented for payment. A/P is recorded on the balance sheet as a liability.
In the construction industry, accounts payable is typically a list of all the money owed to vendors or suppliers. When contractors purchase materials, hire subcontractors, or rent equipment, they must record these expenses into an A/P system. Negotiating longer payment terms with your vendors can be one way to manage your cash flow if they agree to it.
Accrued expenses are liabilities that you’ve incurred but haven’t invoiced for yet. This might be sales tax payable, wages payable, or accrued rent.
The liquidity of your business can be determined by dividing total current assets by total current liabilities. This will give you a number that will help you determine your ability to pay current liabilities when the due dates arrive.
Taking the numbers from the examples above the liquidity ratio is equal to 2.49:
Anything over one is considered healthy and means you’re capable of paying any debts that you’re on the hook for. Anything below one is concerning because it means you’ll likely have a hard time paying off short-term debts and payments you’re obligated to pay.
Equity is determined by subtracting your liabilities from your assets. This number will reflect the net worth of your business (book value). However, this number doesn’t always reflect your personal ownership of the business, nor does it reflect the value of a company.
For example, Apple’s shareholder’s equity is $62 billion, but its market cap is nearly $3 trillion. It’s important to note that for every balance sheet, the total of the assets always equals liabilities and equity. This is known as the fundamental accounting equation.
A cash flow statement is a financial document detailing the cash entering and leaving your business (or specific project) over a specific period of time. This statement will tell you if you are bringing in more cash than you’re spending. A positive cash flow means you’re making more than your spending, and a negative cash flow means you are spending more than you’re making.
It’s typically broken into three activities:
Cash flow statements will help you keep an eye on overall financial health by uncovering where you overspend and where you’re experiencing efficiency bottlenecks. For contractors, cash flow statements are vital for identifying if you’re working enough jobs to ensure you have cash on hand to fund future jobs.
Using cash strategically can be tricky, especially on larger projects with multiple phases. You may want to use any cash that’s coming in right away to ensure the project doesn’t come to a complete stop. Cash flow statements will be your best friend here.
It’s important to never assume that you’ll have a certain amount of cash coming in. Along those same lines, just because you have cash doesn’t mean you’re necessarily free to spend that cash wherever you want.
You can run into several scenarios that will deceive you into spending cash that you shouldn’t or that you don’t actually have. Payment amounts or the timing of payments may change, expenses may start to increase at an unexpected rate, the project may run into a field issue, or maybe your crew is down a man or two.
Any and all of these reasons can result in a situation where you’re spending more than you’re bringing in. In these circumstances, you should really only spend cash coming in from this job back into the job. Don’t start buying new company vehicles or equipment for upcoming projects when your current job is in negative cash flow.
Cash flow management comes down to knowing exactly how much cash you’ll need throughout a project so that you can make the right decisions. For a complete breakdown of how you can improve your cash flow management, check out our practical guide to mastering the fundamentals of construction accounting.
Work-in-progress (WIP) reports are not something you’ll find mentioned alongside financial statements very often. That’s because WIP reports are very niche financial reports used mostly in the construction industry.
While WIP reports fall outside of the major financial statements (income statement, balance sheet, cash flow statement), we’ve decided to discuss how they fit into the picture here because of their relation to cash flow management and importance to the specialty trades.
WIP, as it’s often abbreviated, is the accounting concept that covers the cost of work completed but not yet invoiced. For businesses that operate on a project basis, understanding WIP is essential for determining their overall profitability.
If, for example, the budgeted number of labor hours for a project far exceeds the actual number of hours used, then a WIP report will help you identify and account for this to keep your cash flow healthy. Moreover, such reports give businesses a better idea of what their billings will be at the end of the month, providing a reliable measure of their financial health.
In addition, a WIP report can reveal whether you’ve overbilled or underbilled and, as a result, enables you and other project stakeholders to monitor a project’s progress. Underbilling means you’ve completed more work than you’ve been paid for. This is a classic catalyst for cash flow issues as it’ll leave you strapped for cash as you progress further along in the job.
Additionally, underbilling can cause your revenue to artificially inflate since any revenue that you’re underbilling will be recorded as an asset on your balance sheet. This means you’ve earned revenue by completing the work but you haven’t actually received any compensation.
In contrast, overbilling means you’ve billed for more work than you’ve completed. This can distort your financial standing for the same reason as underbilling. Overbilling means you still need to do the work and you haven’t actually earned the revenue you’ve just invoiced for, which distorts your true financial standing.
The goal is to avoid over or underbilling on a project to ensure your cash is on pace with the work you’re completing. Letting over or underbilling get out of hand can result in the aforementioned scenario where you’re spending cash that you don’t actually have. For these reasons, frequently referencing a WIP report is crucial for contractors to effectively manage cash flow and job progress.
Financial statements allow you to look at your business from a few different angles. Remember that a balance sheet will display your financial position at a moment in time, while income statements cover a period of time (week, quartet, even years). All combined, small business owners can use each statement to make meaningful changes to their business.
Income statements, for example, will help you appropriately recognize revenue in a period of time to determine profitability. Concerted efforts to improve your income statement will result in long-lasting improvements to your business–especially if you take an aggressive approach to job costing. Remember that job costs will fall under COGS.
Job costing is your best tool for tackling common business challenges such as higher-than-expected labor costs, productivity issues, inaccurate estimating, and rising material costs. Through job costing, you can mitigate these issues, dramatically improving job-level profitability. Doing so will inevitably lower your COGS (job costs) improving your gross profit margin. Consistent job costing with the goal of lowering COGS will result in long-lasting financial improvements to your business.
Overall your financial statements will clue you in to the ins and outs of your business. Both the big picture and smaller job level insights. With this information, you’ll have a nice launching off point for adjusting prices, optimizing your bidding process, and controlling material, labor, and equipment costs through job costing.
Depending on your business goals you may want to bring on investors or eventually sell your business. If any of these actions are on your radar then your financial statements will play a significant role in determining your future. Financial statements will demonstrate your potential for growth and reflect your history of financial stability over time. This information can be used to appeal to lenders, investors, and banks.
Outside parties will run through your financial statements with a fine-toothed comb. Even if things aren’t where you’d like them to be now, consistent improvements over time will definitely be noticed. The more time and care you can put into your financial statements the better position you’ll be in when it comes time to seek investors or buyers.
Did you spend extra time training your team? Did you just invest in a new piece of software? Have you been trying to lower labor costs? Financial statements will help you determine the effectiveness of some of your larger business decisions. While every job will vary, so will the decisions you need to make.
If you’re making a large amount of small adjustments throughout the year, your job costing will help you determine profitability and efficiency per job, but your financial statements will help you identify the accumulation of these adjustments.
It allows you to take a step back and gain a bird’s eye view of your business. This can help you evaluate the true impact of your decisions and job-per-job adjustments as a whole.
Consistently running reports on your financial statement will allow you to track and assess progress toward business goals. You can compare results against your goals to see how you’re pacing. This should also provide visibility into potential problems, giving you an opportunity to address issues while working towards your goals.
Use cash flow statements to better understand and manage the cash flow for your projects. Ensure you have enough capital to fund projects individually. You want to avoid funding a project with the cash you just received from a past job.
Use cash flow statements to help identify where you consistently run into cash crunches. Try to pinpoint if there are trends in terms of specific phases or job types that seem to always result in additional cash needs. Use this information to better anticipate financing needs and operational gaps in cash so you can prepare.
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See for yourself by booking a free demo with a Knowify expert today!
