Nasty Numbers – 8 red flags to watch out for in your financial statements
Financial statements show not only where a construction company stands financially, but also where it may be headed. Contractors who work with their financial advisors to analyze their statements can often catch problems early on — before they turn into bigger issues. Here are eight red flags to look out for when reading your next statement:
If you’ve been in the construction business awhile, you’re likely familiar with most of the key words on your financial statement. Nonetheless, it doesn’t hurt to review these terms and think about how they currently apply to your company. Here’s a handy financial statement glossary:
Balance sheet. This provides a snapshot of a company’s assets and liabilities. Assets are items of value, including cash, accounts receivable, equipment and intellectual property. Liabilities are debts such as accounts payable, payroll and lines of credit. The balance sheet also states the company’s net worth, which is calculated by subtracting total liabilities from total assets.
Cash flow statement. This shows how much cash a company generates for a particular period, which is a good indicator of how easily it can pay its bills. The statement details the net increase or decrease in cash as a result of operations; investment activities, such as property or equipment sales or purchases; and financing activities, such as taking out or repaying a loan.
Income statement. Also known as a profit and loss statement, the income statement shows revenues and expenses for a specified period. Its goal is to depict which parts of the business are profitable, so it matches revenues and expenses carefully for specific projects.
Retained earnings/equity statement. This statement shows how much a company’s net worth grew during a specified period. If the business is a corporation, the statement details what percentage of profits for that period the company distributed as dividends to its shareholders and what percentage it retained internally.
- An accumulation of cash (or lack thereof). A strong cash flow is one of the hallmarks of a successful business. But the key word here is flow. A growing but static reserve of cash can be a sign that your backlog is dwindling and you’re running out of work, leading to a stockpile in the cash column.
On the other hand, if you find yourself drawing on a line of credit when payments for a given project are slow in coming, you could also be headed for trouble. A construction company should always be in an overbilling position on a job. If underbilling is occurring, ask your financial advisor to perform an over/under billings analysis to get a handle on this dilemma.
- Declining equipment value. Slow periods in your business can lead to an unnoticed decrease in your equipment’s value and force greater spending down the line. You may be tempted to think that, because your assets aren’t getting as much wear and tear, they’re maintaining their value.
But, just as it does for a new car driven off the lot, annual depreciation continues to steadily do its work on your assets. Plus, you’re not buying replacement equipment at current market prices — meaning you’ll likely pay more when you finally have to upgrade.
- Significant liability changes. Substantially changing liabilities warrant a close look. If your profits are dwindling, for example, certain liabilities may shrink as well, such as payments to profit-sharing plans or deferred tax liabilities.
On the other hand, liabilities can balloon if you take out a loan to keep your construction business afloat. Having a large amount of unsecured debt is a particularly bad sign for any company.
- More current liabilities than current assets. Because many contractors have seasonal swings in their businesses, you may have more bills to pay than cash on hand at one time of the year or another. This is something worth tracking and planning around. Also, consistently having more current liabilities than current assets is typically a sign that you’re over leveraged.
- Shrinking gross profit margin. Your gross profit margin is equal to your building costs for a particular period — not including overhead, payroll, taxes and interest payments — divided by your sales revenue for the same period.
If this ratio is dwindling, it means your production costs are rising more quickly than your prices, or you’re charging less for your construction services (perhaps in an attempt to gain market share). Both trends can sink your business quickly, so track your profit margin closely.
- Increasing ratio of general and administrative expenses to profits. General and administrative expenses, such as rent and utilities, are less “elastic” than project expenses, such as labor and materials. Thus, the ratio of these expenses to profits will skyrocket if your workload sags.
Also keep an eye on indirect costs, such as insurance, that you allocate to each of your contracts. If the amount of these rises significantly, it’s often because you have fewer contracts to allocate these expenses to, which could spell financial trouble.
- Receivables growing faster than sales. If your receivables start to dwarf your actual sales, beware. It may be a sign that customers are taking longer to pay their bills — or not paying at all — and that it may be time to revamp your collection procedures.
- Far-off or unprofitable future projects. Although you may take comfort in the sight of a lengthy project backlog on your financial statements, remember that not all projects are created equal.
If you have jobs scheduled in the distant future, but nothing for the next few weeks (or months), start strategizing how to pay your bills immediately. Quality also trumps quantity: A smaller number of profitable jobs may prove more beneficial than a large number of jobs with slim profit margins — or even potential losses.
