Frank Blau
Contributing Writer
ShuBee®
Do you know what it costs to operate your business on an hourly, daily, monthly, quarterly or semi-annual basis? I routinely ask this question of contractors in my seminars and consulting work. Unfortunately, less than 10{938cd9e8dae860e800efc538277d4f7684e6f6981618ba70d1c34357a53c2e1f} can look me straight in the eye and say “yes.”
How long has it been since you’ve taken a serious look at your balance sheet or profit and loss statement? (I’m tempted to ask how many even have them, but why ruin such a nice spring day!)
Most of you might glance at either of these important documents once a year. If that’s the situation, you really don’t know what’s going on with the most important part of your business – your MONEY.
Certain minimum information is needed to manage a business. Fist, you need information on overall operations – the big picture, or the “forest.” Second, details are needed on various operating segments of the business, the “trees.”
Business transactions continually change the content and dollar amounts of assets, liabilities and net worth of the business. It is necessary to periodically summarize the results of these transactions in the form of financial statements.
Financial statements are necessary to present the most important data in certain standard terminology and outline for, in order that persons interested in the business can gain pertinent information. The basic statements which provide information on overall business progress are the “Balance Sheet” and “Profit & Loss Statement.”
These documents, the balance sheet in particular, provide a snapshot of the financial health and position of a business at a precise point in time.
The Balance Sheet: Like human beings, businesses become ill. The balance sheet is the doctor’s instrument that tells if the patient is well or faltering. If sick, then a proper prescription must be written and administered to get back on a healthy and prosperous track.
This financial statement is usually prepared at the end of the month, quarter, year or accounting (“fiscal”) year. It lists the values of the business that are owned, referred to as assets; debts owed, or liabilities; and the owner’s investment, known as net worth.
All of this must be presented in a standard manner and using accepted principles of accounting, applied consistently. The reason for this is so that interested outsiders – bankers, accountants, lawyers, the IRS – can compare apples to apples.
Generally, assets are listed in the order of their probable realization in the form of cash or benefits, and are classified as current assets, deferred assets, fixed assets and other assets. Liabilities tend to be listed in the order they become due and payable. The form of net worth presentation depends on the type of business, whether a sole proprietorship, partnership or corporation.
Assets: What follows is a quick glance at some typical items, as they might appear in order on a balance sheet. Some balance sheets may show other classifications, but we’ll limit our discussion to the example shown here, starting with assets.
Current Assets: Current assets include cash and other financial devices that are expected to be converted into cash, sold or consumed during the normal operating cycle of the 12-month fiscal year. They generally are listed on the balance sheet in the order of their liquidity (meaning how fast they’ll be converted into cash), i.e.:
1) Cash.
2) Notes and accounts receivable.
3) Jobs in progress payments.
4) Inventory of material.
Deferred Assets, sometimes called “Deferred Charges”: These represent dollars spent on things whose benefits will be applicable to future accounting, extending beyond the current balance sheet date. These typically are prepayments for items such as insurance, supplies, rent, etc.
Fixed Assets: These represent the investment in something tangible that is involved in the production and operation of a business over a long period of time – automobiles, trucks, tools, shop equipment, office fixtures and furniture, real estate, leasehold improvements, rental equipment, etc.
This type of asset has some permanency and is not intended for resale during normal operations. Their life usually extends beyond the current balance sheet date. While these assets are being used, their market value decreases. This is addressed through “depreciation,” which is an indirect cost and identified as part of overhead.
Other Assets: These may include items such as cash surrender value of corporate life insurance, security deposits, escrow funds for warranty claims, investment in unconsolidated subsidiaries, goodwill, trade marks, etc.
Liabilities: The debt part of the ledger usually is expressed as current liabilities and fixed liabilities.
Current Liabilities: These include debts of the business that are payable to creditors and others within 12 months from the date of the current balance sheet. Items normally found under this classification are trade accounts payable, consignment payables, sales deposits, current portion of long term debt, payroll taxes, sales taxes, vacation pay, predictable charitable contributions such as “United Way,” plus accrued expenses such as payroll, corporate income taxes, interest, pension plan and profit sharing contributions, etc.
Fixed Liabilities: These are not due for a long period of time, usually beyond one year. One example is a mortgage on a real estate used in the business. (I prefer to own real estate personally than have the business own it, for tax reasons and corporate liability reasons.)
Net Worth: There are a lot of possibilities here, but two of the more common items would be:
Capitol Stock: This measures the initial funds used to start the business.
Retained Earnings: Profit dollars, after taxes, which accumulate through the life of the business.
I’ve included with this article a reproduction of my corporate balance sheet (attached). I have used this format for many years, and it has given me the vital information I need to continuously track the financial health of my business. You may want to compare it with yours.
I stated earlier that the balance sheet is like taking a financial snapshot of the business at a given time. The real significance of this information is not so much in the dollar amounts on the sheet, as in the relationship and comparison of various balance sheets.
A single balance sheet review gives limited insight. More important is to analyze and compare them from year to year in order to detect financial trends that are shaping your business. This is the information that enables you to plan for profit and the future in a confident manner and, above all, as a competent, professional businessman, one who is aware of what it will take to stay in business profitably.
Ratios: The real meat of a balance sheet is expressed in the form of ratios that show, basically, how much money you have compared with how much you owe. Most contractors that I’ve spoken with in seminars have trouble grasping these concepts, or at least their terminology.
Current Ratio is one of these key terms. It is determined simply by dividing current assets by current liabilities. The answer is current ratio.
The higher the current ratio, the freer the current assets are from claim by those you owe dollars to, and thus the more likely creditors are to receive prompt payment from you. The banking industry has long recognized a 2:1 current ratio as the general rule of thumb for good financial health, and the number that will encourage them to lend money. The general rule has many variations, of course. Different ratios apply to different kinds of businesses, and individual circumstances also come into play.
Another ratio is very important for the business owner to understand is the Acid Test ratio. This is a supplement to the current ratio. Instead of including all assets, you only count those that you can convert to cash quickly. In fact, the “acid test” is sometimes known as the “quick ratio,” and as you’ll see, with good reason.
The acid test is arrived at by dividing the total of cash and accounts receivable by current liabilities. If cash and accounts receivable are equal to current liabilities, this is an indication of a financially sound business. It shows that the business would be able to pay all current debt (liabilities) without having to sell more work than it is presently doing. This is a rather drastic test that all PHC contractors should put their companies through.
Another ratio that is near and dear to a loan officer’s heart – and should be to yours – is the Debt to Net Worth ratio. This is calculated by dividing total liabilities by the net worth or “equity” of the company.
This ratio measures money invested by the owner of the company compared with borrowed funds necessary to run everyday operations. As the ratio increases, it signifies more money borrowed. If this happens over a period of time, it’s an indication to the banker, and should be to the owner, that the company is increasing risk.
Keep in mind that borrowed money costs more than owner-invested money because of the interest. And borrowed funds must be repaid regardless of economic and market conditions. Imagine what happens if the “bottom falls out”. You could lay off people, sell various assets and take other actions to remain solvent, but you still would be responsible for paying back borrowed money, with interest. Could you do it? Could you stick it out until the market turns up again?
Contractors involved in the new construction market must be especially vigilant in monitoring the financial status of their companies. This type of work requires a large investment from the contractor at the beginning of the job, but no payment from the customer until much later. The only real way to know the financial health of your company in this market is to “crunch the numbers” and compare them with where you expected to be and where you’ve been.
New construction also is a very cyclical business so it is vital you pay attention to what work is down the road, in addition to what you’re building today. A rise in interest rates or a drop in the stock market could limit your customers’ building plans and the amount of work you get. That, however, won’t matter to the bankers and creditors you owe money.
A prudent businessman needs to be aware of these kinds of situations at all times. Financial statements are intended to keep him informed. An owner who doesn’t take the time to learn what all the numbers mean is in for serious trouble, heartache, many sleepless nights and worse.
An ancient philosopher once said, “Eternal vigilance is the price of success.” The bigger the price you pay in the “numbers crunching” of your business, the greater your success will be.
Good luck, good health, prosperity and God bless.
Part VII Financial Statements