AAFCPAs reminds readers of the critical importance of the balance sheet, and advises our construction clients to ensure their presentation of this statement of financial position is optimized in order to demonstrate a solid foundation. Your balance sheet provides a ‘snapshot’ of your company’s financial position at a single point in time, and provides critical insight to surety and bank lenders regarding your ability to meet short and long-term debt obligations.
AAFCPAs provides the following best practice recommendations to ensure your balance sheet is best in class:
- Cash – The old adage ‘Cash is King’ is true for many businesses, however it is extremely important for contractors who must have liquidity to make payroll and fund future job costs. AAFCPAs advises clients to perform cash flow projections weekly or monthly if you operate with low liquidity or working capital, and quarterly or annually if your operations are more established. Cash flow projections should be analyzed by job, and for the company overall, and account for: your receivable and payable turnover, and other monthly expenditures like payroll, rent, leases, and debts that do not go through accounts payable.
- Contract Receivables (Current and Retainage) – The A/R Aging is typically the second most requested document by users of your financials. The construction industry is known for stretched out payment terms, however, unless the receivable is in retainage, after 60 days the money becomes harder to collect in full. AAFCPAs advises clients to ensure receivables are current, and if you identify receivables that are questionable, it is prudent to provide a reserve for those receivables. We also advise clients to formalize their collection activities, such as: ensuring that billing requisition forms, or “AIAs” receive sign-off by the appropriate parties, and collection calls are made at 45 days. Additionally, retainage on closed projects is even more difficult to collect. Although projects may need to be completed in order to have the retainage released, often amounts get paid more quickly when they are asked for as the project nears completion.
- Unbilled Contract Receivables – Again, as outstanding balances age, they become more difficult to collect because they may be perceived as disputed change orders, cost overruns, or bad estimates. In order to minimize disputes and optimize receivables, bill for costs and profit as soon as the work is complete. Monitor your unbilled contract receivables, and set expectations with your team that these will be billed for within 10 days of project completion.
- Under Billings – Users of your financial statements scrutinize costs and estimated earnings in excess of billings on uncomplete contracts. Naturally, you bill for costs that are valid; so again, it may be perceived by users of your financials that you can not bill for these, which would result in a write down on the job, and profit fade. AAFCPAs advises clients to facilitate monthly cost meetings with your project managers to discuss under billings, and to stress the strain these put on liquidity and profitability. (See our previous blog on utilizing the construction WIP to monitor key performance indicators and trends affecting profitability, and to download a sample WIP schedule template, which includes standard, predefined columns that will be helpful for many contractors in measuring and analyzing their WIP results.)
- Prepaid Expenses – Generally prepaid expenses include insurance, taxes, or expenses that provide future benefit. When simply recorded on the P&L, these expenses can distort earnings from month to month. Ensure you have proper cut off procedures to reflect items as prepaid or as expenses in the correct period.
- Officer Loans – Officer loans should be avoided if possible, because sureties and bankers do not see these as lendable assets. These can also come into question by the IRS, who considers these to be distributions. If an officer loan is necessary, you should have a documented plan for addressing the pay back, including terms and timeline.
- Property Plant and Equipment – PP&E are fixed assets that have been capitalized, and will be depreciated over their economic useful life. These are carried at their historical value, which may be different than fair value. AAFCPAs advises clients to use accurate useful lives, and record depreciation on a monthly basis to not give contractors a false sense of profit.
- Short Term Debt – Short term debt encompasses maturities due within the next twelve months, typically on vehicles or equipment that might be financed. This impacts working capital calculations as well as debt covenant calculations. We recommend amortization schedules on all debt that reflects accurate short-term portions in the current liabilities.
- Accounts Payable (Current and Retainage) – Your accounts payable represents all amounts due for work/services received, including those to: subcontractors (including retainage), service providers, utilities, etc. Ensure your payables are current, and you do not stretch out payment terms resulting in interest charges. You may also take advantage of discounts provided by vendors/suppliers if you pay early. Best practices in accounts payable can be achieved with proper cash flow projections.
- Billings in Excess of Costs and Estimated Earnings on Uncompleted Contracts – Overbilling on projects may help with cash flow, but may result in job borrow. Additionally, overbillings may be perceived as, or an indication you are overly conservative in job estimates. Again, monthly cost meetings are crucial to provide finance with insight into where each job stands.
- Accrued Expenses – Accrued expenses encompass all other amounts owed outside payables or debt. These can include payroll earned but not yet paid, 401k matches, PTO liabilities, income taxes, payroll taxes, etc. It is important to have proper cutoff procedures to capture all expenditures in the correct period.
- Long Term Debt – Long term debt represents the balance of what you owe beyond twelve month maturities. Monitor how leveraged the company is by looking at debt to equity ratios. Generally best practice is less than a 2:1 debt to equity ratio.
- Equity – Preserving equity in the company should be a top priority, especially if you are growing and looking to increase bonding capacity. If distributions are necessary, e.g. to pay income taxes for owners, discuss the impact prior to taking equity out of the business. Consult with your AAFCPAs tax professional to plan accordingly in order to limit the need for tax distributions.
AAFCPAs encourages contractor clients to benchmark their performance metrics against the industry norms. Valuable balance sheet performance indicators include: current ratio, quick ratio, working capital, debt service coverage, return on equity, return on assets, AR turn and days outstanding, AP turn and days outstanding, revenue to working capital, debt to equity, and current debt to equity. Monitoring these indicators and reviewing your balance sheet on a monthly basis will ensure financial stability over the long term.
This article appeared in the Spring 2018 issue of The Professional Contractor (TPC), a quarterly magazine published by the Association of Subcontractors of Massachusetts.