Can you become a successful, prosperous contractor without a solid grasp of the financials? It may be possible, but the odds are against it. Most extremely successful contractors have a solid grasp of the financial aspects of running a service business. Here are four things you should know—at a minimum—about finance.
If you do not have a good grasp of the financials, it is probably because no one ever taught you. No one is born knowing their way around financial statements. This must be learned. It is up to you to learn it. Fortunately, there are lot of resources in the industry where you can pick it up.
1. Understand Your Income Statement
The income or profit & loss statement is about as basic as it gets. It shows the flow of money through a business over a period of time, such as a month, quarter, year, or year to date.
Basically, revenue minus direct costs of sales equals gross profit. Gross profit minus overhead equals operating profit. You must understand what expenses are direct and what are overhead. Then you need to ensure your gross profit is strong enough to cover your overhead expenses.
2. Understand Your Balance Sheet
The balance sheet shows the financial value of a business at a specific point in time. It works with the income statement to give you a picture of the fiscal health of a company.
The balance sheet shows the balance between assets and liabilities. The difference between them is the owner’s equity in the business. This is often called the book value. In theory, this is what the owner’s would have if every asset was sold for its book value and every liability was paid. So, assets minus liabilities equals owner’s equity.
The most important two items on the balance sheet are your cash and your receivables. No business was ever forced to close if lots of cash was on hand. Businesses close when they run out of cash. Too many receivables is a good way to run out of cash. While some commercial customers might insist on being invoiced, you should keep them to a minimum and all residential work should be collect on delivery.
3. Know the Difference Between Margin and Mark-Up
A surprisingly large number of contractors get mark-up and margin confused. If they have $100 in direct costs and want to earn a 60% gross margin, many contractors will simply mark up the $100 by 60% and arrive at a selling price of $160. However, $60 in profit divided by a $160 sales price results in a 37.5% gross profit (60 / 160 = 0.375). The contractor underprices.
To get a 60% gross margin, divide the direct costs by one minus 60%, or 40%. When you divide $100 by 40%, you arrive at a selling price of $250. To check it, divide the gross profit (i.e., $250 sell price - $100 direct costs = $150 gross profit) by the sell price. Divide $150 by $250 and the result is 0.6 or 60%.
4. Know How to Price
Most contractors have little understanding of how to price for profitability. This is the most common problem in the industry and the easiest to correct. Start by understanding overhead and where it should be assigned.
Start with the simple concept that labor carries more overhead than material. Accordingly, overhead should be associated with labor. If you figure out your labor selling price and all of your overhead is spread over your projected billable hours, you will be profitable whether you are selling a high labor or high material job. Moreover, you will not underprice or overprice either.
There is more to know than these four items. For example, you should become well-versed with the key business ratios that apply to your business. You would also develop key performance indicators (KPIs) for your business that can help you know at a glance how smoothly things are operating or whether you need to look under the hood. However, these four areas: the income statement, balance sheet, understanding the difference between mark-up and margin, and knowing how to price will put you on a path to prosperity.
Buy Matt Michel’s book, “Contractor Stories” at Amazon. See him speak at the Service World Expo in October, where he is a keynote speaker. Learn more at www.ServiceWorldExpo.com.