How to Read Your Financials – Costs in Excess of Billings

It is imperative to understand how to read your financials. They represent the “financial control” of your business. Costs in excess of billings are costs you have not or cannot bill to the customer right now on jobs still in progress. Billings in excess of costs are ones the contractor has billed the customer for regarding work not yet done.

Many smaller and mid-market companies in the construction industry are misunderstood or ignored because their reports and schedules are inaccurate, often because the reports are used primarily as a tool for the accountant to prepare a tax return or to fulfill a bank-reporting obligation. But your reports and schedules, when organized, will inevitably help your profits. They represent the “financial control” of your business. It is imperative to understand how to read your financials.

A Balance Sheet

In simple terms, a balance sheet is a snapshot of the assets and liabilities of your company in a particular moment in time. It shows where you stand with what you own and what you owe on a particular date. Your assets are listed “at cost” minus any depreciation or amortization taken over the ownership period of the asset; nothing is shown at fair market value. Your balance sheet should list the amount of money the stockholders will receive before capital gains taxes on liquidation, plus or minus the fair market value of the assets versus the value stated on the balance sheet, (or the “short fall” if there is a negative equity).

The purpose of the balance sheet is to control the accuracy of the income statement.  If your balance sheet is substantially inaccurate on the opening or ending date of the income statement period, then the income statement will be substantially wrong. For example, the income statement for the year ending 12-31-06 would need an accurate balance sheet dated 12-31-05 and 12-31-06.

I met with a new client recently whose accountant not only lost his records for the past three years, but could not locate his records for the current year.  Knowing that accountants do not ever lose that many records and knowing that accountants normally back up their computer records, I knew we had a big problem. 

My client thought he had generated about $6 million in revenue from the past twelve months as a result of the revenue generated from his high-end New York City co-op remodeling projects. He had pretty good job cost and billing data but needed bank financing. He had a horrible bid-to-award ratio, and he needed guidance with his plan of revenue and profit for his company. He needed to know:

•     What his margins should be in order to win bids
•     How to identify who his customers should be
•     If his bid margins allowed for profit after general conditions and overhead
•     Whether he was making money or losing it
•     What had happened to his business over the last three years

My client and I were in a situation where we could not wait for his new accountant to slowly reconstruct his last three years of records, so we sat down and created a balance sheet. I interviewed him to determine what he owned and owed, located records which included his bank statements; accounts receivables; retainages receivables; an inventory of his trucks and computers; his vendor and subcontractor payables; the amount of debt on his trucks, cars and equipment; the jobs he had in progress; and the estimated costs of those jobs to complete. With that information, I created a balance sheet that covered the beginning and the eleventh month of his fiscal year.

Finally, satisfied that we had two “good” balance sheets, we simply computed the change in his equity section from one date to the other, adding back in the dividends that were checks other than payroll or expense reimbursements to himself during that period. Then, we looked at the payroll records to compute what he earned in salary during that same eleven month period. 

Our final step was to combine what he earned in salary and profit for the eleven months reviewed. The combined information, within a quick couple of hours, gave us the amount the client had earned. So, when you are unsure of your financial situation, use this short-cut to make sure your balance sheet is correct. Otherwise, look no further at your financials; they will likely be inaccurate and useless.

Estimated Cost to Complete Jobs/Projects

It is my experience that nearly all contractors use the “percentage of completion” method of recognizing revenue and cost other than the residential developer/builders who use the “completed contracts” method of accounting for revenue and cost. “Completed contracts” means just that: When the job is completely done, you “book” or record the total income and expense of construction on the income statement. No income, job expense, profit or loss related to the specific job is to be recorded on the income statement until the home settles. Prior to that, the job costs appear as an item on the balance sheet named “work-in-progress.” Revenue appears as customer deposits, deferred revenue or an item of debt.

“Percentage of completion” means that revenue is recognized as income at the rate the job is completed. Job costs are recognized at the rate they are incurred in ratio to both revenue recognized and total job costs expended to date, plus what is estimated to be incurred to complete the job. Your balance sheet will have an asset entitled “costs in excess of billings,” meaning that you have costs you have not or cannot bill right now to the customer on jobs in progress.

A liability account, or “billings in excess of costs” means that the contractor has billed the customer for work not yet done, which is where all contractors would prefer to be -placing the contractor ahead of the customer on a cash flow basis. If the costs in excess of billings are greater than the billing in excess of costs, you will likely have a cash flow problem. This means that either you are spending faster than you are billing, your project managers are behind in getting their bills out, or you have costs on your balance sheet that are really losses such as job overruns or change orders that are not or will not be approved.

All jobs with costs in excess of billings should be lumped together under a liability account on the current asset side of the balance sheet. Always double-check for losses not yet recorded. You, as an owner, may not know about the losses. A project manager might simply fall behind in billing, which costs you interest expense, poor vendor relationships, cash heartache and sleepless nights. If your “billings in excess of cost” are always substantially higher than your “costs in excess of billings” it is good for current cash flow as long as that difference is rising. However, this will give you a false sense of cash security once the job comes to an end because the cash flow slows down. The excess billings over costs are not profit; they are simply a positive cash flow timing difference that will change from time to time.

The “schedule” of closed jobs and the open jobs “estimated costs to complete” should be prepared more than once a year when the accountants request it. This maintains a current review of each job’s status and addresses problems while the job is ongoing, since you will have problems to face during the project. Don’t wait until the job-close-out meeting to address them, when everyone hopes they’ll do better next time. Instead, confront problem situations earlier in the project.

Review schedules and reports to estimate an opportunity to bid higher or correct a problem in the bid process. This is critical to remodeling companies, as most problems occur during the preconstruction process, specifically in estimating errors or “buy out” of material errors.

The Benefits of Regular Reporting

Our firm instituted a weekly job review and estimated cost to complete process for one of our remodeling company clients. Job margins for the client increased by twenty points as a result of immediately identifying problems and making corrections in preconstruction in the future. Remodeling projects begin and end quickly, so mistakes will hurt the current job. Those mistakes do not have to be repeated if you institute weekly reviews and estimates. 

It can be difficult and time-consuming to correctly prepare an estimated “cost to complete schedule” for larger jobs in their early stages, yet it is worthwhile. You may continue to assume your estimate is correct. However, the estimator, project manager, job superintendent and controller must review a job early on to determine what is needed to complete and uncover looming problems. That step will create better value engineering, change orders will be billed in a timely manner and job profit will increase.

Schedule of Cash Flow & Working Capital

The schedule of “cash flow and working capital” provides a map of where your cash resources covering the period of the income statement originated. It consists of profit, new loans or repayment (principle due more than twelve months in the future), purchases or sales of capital assets and depreciation. All of these have the effect of increasing or decreasing cash.

An accurate reading of the schedule allows for better billing practices, better collection practices and prevents slower paying of vendors and subs. It shows where and how money was used to absorb losses, the debt principle repayments and may contribute to faster paying of bills. It prevents poor billing practices, slow receivables and reflects retainage receivables, purchase of equipment or other assets. If the opening and closing period balance sheets are correct, then this schedule will be correct. Remember, though, if the balance sheets are not correct, do not waste your time looking at this schedule or any other financial statement because they will be wrong!

Working capital is defined as the total of “current assets” comprised of your cash, receivables, retainages, costs in excess of billings, work-in-progress, inventories and prepaid expenses minus your current liabilities. Your current liabilities are comprised of your lines of credit, principle payments of debt due within twelve months, accounts payable, accrued expenses, payroll, taxes, billings in excess of costs, customer deposits and deferred income. A greater than 1:1 ratio is important. Your bank may require a defined working capital ratio, so check your loan documents. If the ratio is too high, you’re likely wasting the use of your cash and resources by making them too idle.

A good business analyst will determine the amount of excess working capital/cash that is funding the income statement profit versus normal operations. I have seen many multi-generational businesses with excessive working capital, but upon quick analysis of a profitable income statement, I saw a generous financial income derived from discounts from vendor early pay, interest income and low interest expense. It was a poor business operation masked by the working capital wealth of the company.

Income Statement

Your income statement should be a validation of what is going on with your jobs in the field, assuming that your opening and closing balance sheets are correct. Your income statement should be in the same category as your job-cost comparison to your estimates, and it should be in a format that highlights whether components of your business are operating according to plan. In order for your income statement to be used as the effective management tool and “sanity check” that it was meant to be, the following components must exist:

• It must be an accrual, not cash basis statement. Accrual means you have recorded all your receivables and debt inclusive of payables on the balance sheet.
•  It must include not only numbers next to the expense categories but also percentages of revenue next to the number.
• The only revenue in your top line should be job revenue. No interest income, rebates or sales of equipment should be included.
• The costs of construction must be detailed to identify construction labor and payroll added costs, subcontractors, materials, equipment rentals, revenue-driven liability insurance, superintendents’ costs or other direct costs of construction as detailed in the estimate and tracked in your job cost reports. Some or all of these are your “direct job costs”. Labor, materials, subs, equipment rental, permits, direct insurance, etc., are at a minimum included on your job cost reports, regardless of software, and in the estimate.
• Indirect construction costs such as mobilization, trucks, pagers, cell phones, supers, trailers, etc., may be what you call “general conditions.” Define what you mean by “general conditions,” and categorize these costs separately on your income statement.  This will allow you to see if the general conditions you are using in your estimates are making or losing money.
• Categorize your preconstruction costs of estimators and bidding/selling expenses separately on the income statement. Divide the number of bids or estimates produced into this total, and see what it is costing you to bid. Add that to your bid-to-award ratio and you may find that not only are you wasting money in bids you’ll never get but also how much you are wasting.
• Keep the office and support staff under an administrative expense category. Be sure to allocate the workmen’s compensation insurance, vehicle and equipment insurance, depreciation, payroll taxes, benefits, safety and training to the indirect or general conditions as appropriate.
• Show purchase discounts and interest income as “other income” after computing profit or loss from the construction operations. These are financial incomes which are earned due to ownership, equity and working capital, not from operations.
• Compare the percentage of gross profit from jobs completed and jobs in progress to your income statement. This should be done before general conditions are deducted when you compare the percentage of gross profit. Be aware of additional profit that you may earn in gross profit from the labor rate that you use in estimating versus your labor rate posted to job cost sheets or categorized on your income statement. If you use your own equipment in construction in lieu of renting it, separately analyze these costs to see if you are making or losing money in this regard. If you are earning a profit from this, that’s great, but it will likely distort the gross profit from construction if your estimate utilized a fair market rental rate.

Meet regularly with your outside accountants if they are construction knowledgeable or your construction business advisor and/or your controller on a monthly basis to review your balance sheet, income statement, working capital, source and use of funds statement and completed jobs/estimated costs to complete schedules. It establishes control in your business. It also helps create the “sanity” of profit, helps avoid the “insanity” of making the same mistakes over and over again and prevents you from losing profit-or your construction business itself.

Construction Business Owner, September 2007