Articles Written by Charles Vander Kooi

Learn from your balance sheet

By Charles Vander Kooi

A financial statement is one of the most important tools – and one of the most neglected tools – you can use in managing a business. It is neglected simply because many contractors do not know how to use it or what it tells them about their company. In this article, I want to discuss how to use the first part of the financial statement, the balance sheet.

Balance sheet – reconciles the worth of a company by balancing the liabilities with the assets.

Liabilities – money owed.

Assets – money the company has or that is owed company.

The balance sheet can best be evaluated by looking at the general indicators it provides you.

Indicator 1.

The first indicator is the relationship of accounts receivable to accounts payable.

Accounts receivable – amounts owed to you.

Accounts payable – amounts you owe.

If accounts payable are greater than accounts receivable, then the company is "upside down," and unless there is cash to make up the difference, that company is in serious trouble. In fact, it is on its way to bankruptcy unless a profit can be turned within 12 months to reverse the condition.

A company that is operating upside down much beyond a year will almost always go bankrupt.

Ideally, the relationship of accounts receivable to accounts payable will be 1.5:1. So, for every $1.50 owed to you, you owe $1.00.This kind of ratio shows that you are doing a good a job of collecting receivables and are paying your payables in a timely manner.

If the amount owed to you is greater than in the ideal ratio, it is a sign that receivables are not being collected in a timely manner or that payables are being paid too rapidly. In order to maintain a good cash flow, you must walk a fine line with suppliers so that you are not paying them too quickly in relationship to how quickly you are being paid by clients. Keeping a good accounts-receivable-to-accounts-payable ratio can help you maintain good cash flow.

Indicator 2.

Your total amount owed in short-term loans (or current liabilities) is another indicator of your company's financial health.

Short-term loans – loans due within 12 months.

The liabilities section of the balance sheet shows how many loans you have out.

If the amount in short-term loans is larger than 1/4 of your total loan amount, you should look into refinancing those loans into loans with longer terms. The exception is if you have a loan from an unsecured line of credit. That loan should not exceed either 6 weeks of payroll or the amount of difference between receivables and payables.

Indicator 3.

The last indicator to look at on the balance sheet is the amount of retained earnings you are using to run your company.

Retained earnings – monies that belong to you – not the company – which you are using to finance equipment, pay receivables, meet weekly payroll or to pay any other company expenses.

If retained earnings are too high, you have become your own bank. While this may seem an ideal position to be in, it is also not a good idea for several reasons.

The construction business is risky. So, rather than keeping a lot of your own money in the company, it's better to spread your risk by using the company as a method to generate cash to invest elsewhere.
You want to develop a long-term relationship with a bank and establish a good history of paying back loans. It may sound crazy, but it's not a bad idea to use a bank to finance your equipment and payroll even when you do not absolutely need to. That way, you establish a line of credit for the company that will be there when you do need it.
The worst time for a contractor to go to a bank for money for the company is when there is financial trouble. A company without a track record with a bank will find the bank much more hesitant to loan them money in a crisis. Plus, if things are bad enough that you can't get that loan, the money you have kept out of the company will be available to bail you out.

Following these concepts and studying your financial statements, you will have the tools – and the knowhow – to run your company successfully. Remember, a financial statement is one of the most important tools a contractor can use in managing a business. Don't let it be the most neglected tool in your toolbox.