There are four basic reports that make up the core financial statements of a construction company: Balance Sheet, Income Statement (or Profit and Loss Statement), Cash Flow Report, and Work-in-Progress (WIP) report. We’ll take you through each of them and describe what they mean – and how they can help contractors improve access to credit, bonding capacity, and cash flow overall.
Learn more: The accounting guide for construction businesses
Financial Statements for Contractors
Unless you’re an accounting or money geek, the thought of reviewing these reports may sound about as exciting as going to the dentist. But, if you stick with us through this article, I promise it will be worth it. When you are a construction business owner, you spend most of your time worrying about the day-to-day operations of your company and putting out fires, so financial statements are the last thing on your mind. Besides, no one knows what they actually mean, and they aren’t that important, right?
Of course, that’s wrong. Financial statements help you spot money problems in your company before they happen. But beyond that, you’ll need these reports if you ever want to prove your company’s creditworthiness to banks, investors, or sureties.
Balance Sheet
A balance sheet report is used to show the liquidity of a company at a specific moment in time. Liquidity refers to your company’s ability to pay its bills in a timely manner. Banks and vendors like to review this report to know if you are a good credit risk. Businesses typically run this report at the end of a period (e.g. at the end of a quarter or year). The balance sheet has three sections: Assets, liabilities, and equity.
Assets include your bank accounts, accounts receivable (customer invoices you haven’t collected yet), inventory, and any fixed assets you own (vehicles, buildings, equipment, etc.). Obviously, the more assets you have, the better your company looks financially.
Liabilities are money you owe and include accounts payable (vendor bills you haven’t paid yet), loans, and taxes due. Here, the object is to have as little as possible.
Equity accounts contain the owners’ investments and withdrawals. The number and name of these accounts will vary by the type of company (corporation, partnership, or sole proprietor). Retained earnings are included in this section and are the accumulated profits over the life of the company, less any dividends or withdrawals by ownership.
On every balance sheet, the total of the liabilities and the equity accounts will always equal the amount of assets. This is called the fundamental accounting equation. Most software programs will figure the equity account balance (usually retained earnings) for you, so no need to stress too much about this.
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Income Statement (Profit & Loss)
An income statement, or profit and loss statement (P & L), shows if your company was profitable or not. This report is one of the most common reports, because everyone wants to know if they are making any money. It will cover a specific period of time, usually a month, quarter, or year.
The report details your income and expense activities during the time period. It starts with your revenue for the period, then subtracts your cost of goods sold (COGS), which are expenses that went directly into projects or materials that you sold (materials, direct labor costs, etc.). The revenue left over is your gross margin, or gross profit.
From there, you subtract your general and administrative expenses (office supplies, administrative salaries, membership dues, etc.). This is your operating income.
Next, you add or subtract any additional income or expenses that aren’t directly related to your business activities, subtract your tax expense, and finally you get your bottom line: Your net income or loss for the period.
Analyzing your income statement over months or years can be very educational. You can spot trends and see problems coming up when you know what to look for. Watch for spikes in expenses or dips in your revenue and see if you can tie them to anything, like the time of year or a significant event in your company. Knowing the effect of these changes can help you prepare for the future.
Cash Flow Statement
A cash flow statement shows the flow of cash in and out of your company during a specific period in time. While other financial statements are more often based on accrual accounting, this report is based solely on the cash entering and leaving your company’s accounts during the period. As such, it is a more accurate reflection of what is going on financially. This report is also known as a statement of cash flows.
There are three types of financial activities on a cash flow report: Operating, Investing, and Financing. Operating activities are the normal day-to-day financial transactions that take place regarding your main business activity. They include your sales income, cost of goods sold, administrative expenses, and taxes. Investing activities include fixed asset (equipment, vehicles, etc.) purchases and sales. Financing activities include sale of stock and certain long-term debt options.
The report shows the net gain or loss in each of the three types of financial activities and arrives at a net gain or loss at the end of the period. Looking at reports from past periods is a good way to help you predict what the future will look like, and cash flow projections are a great tool to help you manage your finances. As with income statements, analysis of these reports for cash flow trends can prove beneficial.
Work-In-Progress (WIP) Report
The Work-in-Progress report (WIP) is a tool used in conjunction with your balance sheet to show the progress on current projects and those under contract. Banks and potential clients often use it to gauge how busy you are, and to review your billing practices. Many contractors try to front-load their billings so they can get positive cash flow early in a project. This may be good in the beginning of a project. But it can lead to trouble when the end of the project arrives and there isn’t much additional income around to pay for costs.
If your income is being recognized on a percentage-of-completion basis, then you need to set up a WIP report so you can reconcile your billings and costs every month. The report helps you recognize if you have overbilled (front-loaded income) or underbilled on each project and by how much. Add or subtract the cumulative total of these over and under billing amounts from your reported income for the period. This adjustment takes away the advantage of overbilling or underbilling and helps to more accurately reflect your income based on the status of your projects.
The data in the report will vary by contractor, but generally it includes:
- job name
- estimated costs
- actual costs
- percent complete (based on costs)
- estimated revenue or contract amount
- earned revenue (percent complete times estimated revenue)
- actual revenue (what has been billed)
- difference between earned revenue and actual revenue.
The difference on each job is then totaled to come up with an adjustment amount for that period. If your projects were generally overbilled, your income for the period will be reduced, and if they were underbilled, it will be increased.
Financial Statements & Access To Credit
It can take a long time for payments to flow in the construction industry. (In 2019, the average time to get paid was 83 days!) As a result, contractors often rely on vendor credit or credit cards to get through periods of slow or non-payment. In fact, in a 2019 survey of construction businesses, over half (54%) said they use credit or loans to cover labor and materials while waiting to get paid.
The interest you pay on credit can be expensive. This is especially true if you’re using consumer products, like credit cards or short-term loans, that are tied to your personal credit. Banks or other lenders typically offer a much lower interest rates on business loans or lines of credit.
Banks use your financial statements before they will issue a loan or a line of credit. They review these documents to assess your risk of default. Sureties will use these statements to determine your bonding capacity. While your ultimate goal should be to run your business without using credit or loans to cover payment gaps, that can be difficult when you’re working for new customers – each with their own payment habits – on every project. Preparing accurate financial statements may help you access a cheaper line of credit, if you ever need it.
Financial Statements & Bonding Capacity
Before a surety issues a bond, they’ll check your financial statements. They want to make sure that you have the ability to pay your vendor invoices. Getting your financial statements in order can help you grow your construction business. These records can help you qualify to work on a project that requires bonding.
While subcontractors aren’t typically required to be bonded, there is a growing trend for large GCs to require bid bonds. In order to bid on projects that require a bid bond, subcontractors need prequalification from a surety. Because subcontracts are usually negotiated, general contractors seldom require bid bonds. Instead, the general contractor may require a bond prequalification letter from its surety that states the subcontractor’s current bond capacity. However, there is a growing trend for large general contractors to require bid bonds. A subcontractor must be fully prequalified by the surety before obtaining either a bond letter or a bid bond.
Financial Statements & Cash Flow
Ultimately, financial statements can help contractors improve their cash flow. These statements provide a snapshot of how your construction business is doing financially. They can help you spot and solve cash flow problems or worrisome trends before they impact your business. You can identify growing problems with Accounts Receivable (A/R) or low-profit projects to avoid in the future. When used in combination with job costing, the right accounting reports, and with clear goals in mind, financial statements help contractors get paid on time and make more profitable decisions.
If you’re having cash flow problems, these financial statements can often help you access more credit at cheaper interest rates. This reduces your carrying cost, and improves your bottom line.
In order to get the biggest benefit from these financial statements, you must review them regularly. Go over them at least once a month. Be sure to compare numbers from one month to another. This will help you spot possible errors and see trends. Look at past year’s reports also, as they can give you greater insight into your company’s growth.
Learn more: 6 Financial Controls to Prevent Fraud
Types of Statement Preparation
Any contractor can write up a financial statement in Excel and present it to a lender or surety company. But how can they verify the accuracy of the information it includes? Often, construction companies hire a third party to review their financials and prepare a set of financial statements according to Generally Accepted Accounting Principles (GAAP). Here are the different types of statement preparation:
Audited
An audited statement is one that has been reviewed by an auditor, usually a certified public accountant, or CPA.
“This type is what I would love to get the most,” Thea Dudley writes in her book, The Credit Overlord’s Guide to Credit & Collections. “They have professional examination (CPA) and verification of a company’s accounting documents and supporting data for the purpose of tendering an opinion as to their fairness, consistency, and conformity with GAAP.”
In Thea’s book, she writes that audited statements fall into two categories:
- Qualified opinion: This type is an auditor’s opinion that calls attention to limitations of the audit or exceptions the auditor takes to the statements.
- Unqualified opinion: An auditor’s opinion that the company’s financial statements are fairly presented in all material aspects in conformity with GAAP.
Because an unqualified audited financial statement requires the most thorough review and preparation, it is considered the most accurate and complete. It essentially means that the accountant is willing to put their name and credentials on the final result.
Reviewed
When financial statements are “reviewed,” the scope of the auditor’s investigation is much more limited than in a full audit. As a result, they do not carry as much weight. “Reviewed financials are undertaken for the purpose of providing limited assurance that the statements are done in accordance with GAAP,” writes Thea.
Compiled
Compiled financial statements are prepared by an accountant using the information provided by the company. However, during compilation the preparer makes no attempt to verify the numbers included.
Company-prepared
A contractor can prepare their own financial statements internally, without review from an outside, third party. These are generally not accepted for lending or credit purposes. However, they are still helpful in an internal analysis of business performance and decision-making.
Conclusion
See? Financial statements aren’t that boring or scary – once you know what you are looking at. In fact, they can be a great tool to help keep your construction company in the black.