When thinking about the financial big picture, consultant Judith Miller tells her clients to imagine the diagram of the human body shown to schoolchildren. “The heart,” she says is the bottom line. “How much money do you have left over after you pay your job costs, overhead, self? And is that enough to keep the business going when the economy stalls? Enough to keep your employees motivated? To protect you in the long run? To me, that's the heart.”
To borrow from another saying, everyone wants their heart to be in the right place. And the way to do that is to keep accurate records of your business and have on hand a kind of snapshot of what's going on weekly, monthly, yearly. Unlike some things in the remodeling industry, tools already exist for this: financial statements.
“There are three critical financial statements,” Miller says. “From simple to more complex they are the profit and loss, balance sheet, and statement of cash flows. Profit and loss [P&L] reflects the management decisions made in the current fiscal year; the balance sheet reflects all the management decisions since the company's inception; and the statement of cash flows answers the important question, ‘If I made (lost) all this money, where did it go and why am I still here?'”
What follows are some insights regarding the P&L, also called the income statement, and the balance sheet.
Profit and Loss The P&L shows income, cost of goods or services sold, gross profit, overhead, and net profit. When people talk about “above the line” or “below the line” entries they're talking about where expenses are posted, as part of cost of goods or as part of overhead. Cost of goods sold is above the line, overhead below it.
Carolin Fast, treasurer of MRF Construction, a $1.9 million design/build company in Tacoma, Wash., believes the gross profit margin is the most important number. (The margin represents gross profit related to, or divided by, the total sales price. Some people confuse this with markup, which is gross profit related to job costs.) “If you don't have a good GPM then everything else will be a struggle,” says Fast, who does the 11-person company's payroll and bill paying.
As remodeling companies become more successful — garner higher client satisfaction, raise prices — they can go from about 18% gross profit to 40% gross profit over time, Miller says. “Remodelers must have a higher gross profit than commercial contractors or home builders, for example, to support client demands and continue marketing — in order to have a reasonable net profit.”
Fast sees 30% as a minimum, and says “most folks operate at much lower than that, but often think they're operating much higher” because they assign above-the-line costs below the line and end up “tricking themselves into thinking they have a higher gross profit margin than they really do. Anything that has to do with having employees or doing jobs should be above the line.”
In particular, many people don't put in the total cost or “burden” of field employees. “The burden's cost of labor is what it costs to compensate and support an employee in the field” over and above gross wages, says Melanie Hodgdon, an organizational and business consultant for the building and remodeling industries. “It's the whole enchilada.” She sites three components: actual wage; mandatory payroll taxes (such as social security, Medicare, federal and/or state unemployment, and workers' compensation); and soft costs, which vary from company to company and can include vehicle costs and/or allowances, cell phones, radios, pagers, uniforms, tool allowances, clipboards, business cards. In short, “anything a production person is going to be using that is supplied by the company. It all depends on who's defining what,” Hodgdon says.
Some owners pull their salaries out of net profit and some include it in overhead. The problem, of course, is that there may be nothing left to pay the owner. An owner should plan on a regular salary. “The benefit of putting a normalized (standard number) owner's salary in overhead is the ability to budget like a real business budgets,” Miller says. She cautions that the salary should be equal to some benchmark, though, and “not just what they have or don't have in the checking account.” [See Benchmark, August 2006, for more about salary.]
Since Fast and her co-owner husband Mike do other tasks — she does some billable design, and 10% of his time is spent in the field — she puts a portion of their salaries above the line and the rest below. She looked at three months of work history to figure out the percentages.
Says Hodgdon, “You can take some liberties with where you put things as long as when you're analyzing your financial report you understand what it contains.”
Balance Sheet Jonas Carnemark, owner of Carnemark Systems + Design, in Bethesda, Md., likens the balance sheet to “an airplane dashboard. You need to look at all the instruments. You could be at great altitude and speed and almost out of fuel. Or flush on fuel and making great time but find out you're 10 feet off the ground.”
Basically, the balance sheet shows “the net impact of all your management decisions since you started the company,” Miller says. Banks, accountants, and remodelers look for different things in a balance sheet. The bank, from a lender's perspective, is looking at your debt-to-equity ratio — the amount your company owes compared with what you're generating. “They want to see how much skin you have in the game,” says Alan Hanbury, treasurer and co-owner of House of Hanbury, in Newington, Conn. “If your debt-to-equity exceeds 4:1, they think you're a bad risk.” An accountant might look at debt to equity as well, but will be most interested in figuring out your taxes based on income. As a remodeling company owner, you should look at changes, goals, and trends — to look at ratios over time.
Carnemark meets monthly with key managers to go over the balance sheet and other financial documents. They look at figures such as quick ratio (cash plus receivables divided by current liabilities), current ratio (current assets to current liabilities), working capital, and equity, and put them into a spreadsheet to create a graphic — a flash report. “We review the flash report monthly to see whether we are on track with our budget and goals for the year,” Carnemark says. From the flash report, they can chart trends. “It isn't as important for me to know we are at 1.4 or 1.5 in some area, but that we are going from 1.4 to 1.5 and not the other way around.”
Bob Hanbury, co-owner and president of House of Hanbury, says he too looks at the changes. “On a quarterly basis I can see if the cash or receivables have gone up or down. You can get a pulse of what's happening.”
In the example on page 158, Redeux Remodeling shows $175,000 year-to-date profit. An owner might think he or she is doing well, but once you see the negative equity, Miller says, “that taints the nature of the profit. I'm suspicious of the company's management in the long run.”
The company also has a bit more in current assets ($320,000), than it has in liabilities ($296,000). But that's not the whole story, Miller says. The current ratio tells whether a company can pay off everything it currently owes with everything it owns in current assets, but “when we look at accounts receivable we really don't know how healthy those invoices are,” she says. Perhaps the company has a lot of old (past 60 days) client invoices. For a true financial picture, “get rid of the invoices you think won't be paid. Banks don't consider anything beyond 60 days.”
Miller also thinks that the negative $318,000 in retained earnings — the net of all Redeux's profits, losses, and distributions since the company started — is problematic. “The owner may be pulling too much out of the company through increased borrowing.”