The previous five financial management articles stressed discipline and systems, the importance of a solid accounting set up and the critical need for budgeting. Last month's article discussed how our fictitious builder, Chris Smith, analyzes and reacts to his monthly financial statements.
This final installment of the financial management series will summarize the discussion Chris had with his management consultant. We'll also discuss the balance sheet and some key ratios as well as the cash flow statement.One last look at Chris Smith
In the June issue, Chris and Katherine reviewed Chris's Income Statements to see what he was doing right and what he was doing wrong.
Chris had run into some problems (these can be seen in the income statements illustrated throughout the article):
- Indirect costs which were $2,926 over budget
- Unbudgeted hiring costs for a new estimator
- Warranty problems
- Year-to-date indirect costs were slightly over budget at $1,786
- $5,000 over budget on marketing budget
All was not bad news for Chris. Sales were still strong. Chris was in the running for three potential jobs and only needed one of them within the next 60 days to have the volume needed for the end of the year. Two of the three jobs Chris needed to sell to fill the closing slots for June, July, and September had sales prices considerably higher (closer to $400,000) than the $330,000 he had budgeted for. The potential profit margins were strong, but not quite to what Chris had hoped to achieve. With the estimator's help, Chris was sure the next few jobs he sold would easily make the target margin.
Chris was beginning to see how the financials meshed with the operation of his business. He was starting to understand that from variances on the summary income statement, he could find out what went wrong in the office or the field by drilling down through a few simple reports. Chris was working fewer hours and was pretty confident that he would make his target net profit goal of $188,000.
Following are some more advanced concepts regarding the balance sheet, ratios, the cash flow statement and break even analysis.The Balance Sheet
A balance sheet is a snapshot of a business' financial condition at a specific moment in time, usually at the close of an accounting period. A balance sheet has assets, liabilities and owners' or stockholders' equity. Assets and liabilities are divided into short- and long-term obligations including cash accounts.
A fundamental principle of the balance sheet is that Assets = Liabilities + Owners' Equity. An asset is anything the business owns. Liabilities are amounts of money the business owes to someone else outside the business. Owners' equity is the amount of money that owners have invested in the company plus any retained earnings owners or management has decided to leave in the company.What is a Balance Sheet Used for?
A balance sheet can help a builder get a handle on the financial strength of his business. It answers questions such as:
- What is the debt structure?
- Can the business expand?
- Can the business handle the financial ups and downs of revenues and expenses?
- Will the business need to borrow for cash reserves?
Balance sheets can identify and analyze trends, particularly in the area of receivables and payables. Balance sheets, income statements and cash flow statements are the basic elements in providing financial reporting to potential lenders.Assets
Assets are subdivided into current or short-term and long-term assets. Typically, current assets could be liquidated within one year for cash. Some current assets are cash, accounts receivable and short-term notes receivable. Long-term assets, which include long-term loans or investments due to the company, and fixed assets such as vehicles, buildings and land are not as easily liquidated.
Most fixed assets can be depreciated using a depreciation schedule. Buildings, office equipment and vehicles that are used in connection with the business are depreciable. Land is considered a fixed asset but, unlike other fixed assets, is not depreciated, because land is considered an asset that never wears out.
Total fixed assets is the total value of all fixed assets, less any accumulated depreciation. Total assets represents the total dollar value of both the short-term and long-term asset of the business.Liabilities and Owners' Equity
Liabilities includes all debts and obligations owed by the business to outside creditors, vendors or banks that are payable within one year, plus the owners' equity. Often, this side of the balance sheet is simply referred to as "Liabilities."
This is comprised of all short-term obligations owed by your business to creditors, suppliers, and other vendors. Accounts payable can include supplies and materials acquired on credit.
Similar to current assets, short-term liabilities represent money owed within a year or less. Typically, this includes short-term notes payable, work in process and, at times, accrued payroll and withholdings. Total current liabilities is the sum total of all current liabilities owed to creditors that must be paid within a one-year time frame.
Similar to long-term assets, long-term liabilities are debts that are due more than one year out from the current date. This could include mortgages and other long-term notes.
Owners' equity or (stockholders' equity) is made up of the initial investment in the business as well as any retained earnings that are reinvested in the business. Retained earnings are earnings reinvested in the business after the deduction of any distributions to shareholders, such as dividend payments.
Total liabilities and owners' equity is the sum of all debts that are owed to outside creditors and the remaining monies that are owed to shareholders, including retained earnings reinvested in the business. This amount must equal total assets or there is an accounting mistake somewhere on the balance sheet.Key Ratios
There are several financial ratios and they can be quite useful. However, the current ratio and the debt to equity ratio are the two most important to learn now. The current ratio measures how liquid a company is. The debt to equity ratio measures how much debt a company has compared to the amount of equity a company has.
These and other ratios are derived from the income statement and the balance sheet at an exact point in time. Therefore they are not necessarily indicative of the health of the company. Good financial mangers use these ratios as indicators of potential problems. Ratios that are out of normal ranges should be treated the same as when the income statement is over or under budget and that means — put your detective hat on and find out what the issues are!Current ratio
The current ratio is an indicator of company's ability to pay short-term obligations and is calculated by dividing current assets by current liabilities.
In the home building business, the target current ratio is about 1.3. As the current ratio gets closer to 1.0, the more difficulty a company may have meeting its short-term obligations. If the current ratio drops below 1.0, the company has more short-term debt than current assets. If the company has no access to cash via investors, loans, or credit lines, the company may not be able to pay bills and runs the risk of going out-of-business.
The higher the ratio, the more ability the company has to pay short-term debt. Should it be your goal to keep the current ratio as high as possible? The answer depends. When the current ratio is high, check to see how much cash the company has on hand. Too much cash may indicate a poor use of cash. For example, the company may continue to borrow for construction loans and pay interest for those loans, but may have enough cash to use for construction costs. It may be more advantages to use excess cash for construction costs or to pay down long-term debt. Of course that decision also depends on the cost of borrowing.Debt to equity ratio
The debt ratio indicates what proportion of debt a company has relative to equity and is calculated by dividing total debts by equity. A debt to equity ratio greater than 1 indicates that a company has more debt than equity, and a debt ratio less than 1 indicates a company has more equity than debt. When used in conjunction with other measures of financial health, the debt to equity ratio is a key ratio that lenders and investors use to determine a company's level of risk and evaluate if and how to loan money to a company.
In the home building business, the target debt to equity ratio is between 3 and 4. The higher the ratio is above 4, the less likely a bank may be to loan a home building company money. However, some banks have loaned money to builders with considerably higher debt to equity ratios than 4. Lending criteria depends on several things such as years in business, the aggressiveness of a bank, the strength of a market, etc.
Typically, the lower the debt to equity ratio, the less risk a builder may have in regards to debt. Just like the current ratio, a stronger ratio may not be better. When it comes to the debt to equity ratio, typically, your personal risk tolerance should always be considered. If your goal is to have no debt, you may find it difficult to grow your business quickly. If you tend to carry a large amount of debt, watch for warning signs of a slowing market. Cash is king, and during tough times, builders with cash (either in the business, or in a rainy day fund) tend to make it through easier and sometimes grow faster during a down turn.Other ratios
Some other key ratios are return on equity (ROE), return on assets (ROA), the inventory turnover ratio and the quick ratio among others. Your homework is to learn more about the current and debt ratio, and to learn how to calculate ROE, ROA, the turnover ratio, and the quick ratio. There are numerous resources in libraries, bookstores, and on the Internet that will teach you what you need to know.Cash Flow Statement
The Cash Flow Statement shows how a company pays for its operations and future growth, by detailing the "flow" of cash between the company and the outside world. There is no great trick to the cash flow statement. It's similar to your own personal checking account with one big exception — non-cash adjustments for depreciation and occasionally tax deferrals. These are added back to net income when preparing the cash flow statement for a true picture of real cash inflows.
Like most financial statements, the cash flow statement is only a snapshot in time. The frequency of the need for the cash flow statement can depend on the overall health of the company. Some very healthy companies only review the cash flow statement quarterly. However, if a companies current ratio is low (less than 1.3), then a company may prepare a cash flow statement as often as every week projecting out six to eight weeks at a time until the company returns to health.Break-even analysis
(Break Even = Fixed Cost / (Home Price - Variable Cost))
Break even analysis depends on the following variables:
- The fixed production costs for a home.
- The variable production costs for a home.
- The home price.
- The projected home sales
Any of these things can change throughout the year and so break-even can be a moving target. However, it's extremely important to understand approximately how many homes you must produce and close before you start to make a profit.
On the surface, break-even analysis is a tool to calculate the sales volume that variable and fixed costs of producing homes will be recovered. Another way to look at it is that the break-even point is the point that building homes stops costing you money to produce and sell, and starts to generate a profit.