Balance Sheets For Construction Accounting
Balance sheets are one of the most important aspects of construction accounting, so it is naturally best practice to make sure they are current and accurate. However, some small business owners or operators may not necessarily understand what a balance sheet is, let alone how to keep and maintain one.
This article intends to demystify the concept a little and offer some helpful advice on first what balance sheets are, and secondly how you can actually go about implementing one.
What Is A Balance Sheet?
Before considering the benefits of a good balance sheet, we must first understand exactly what it is.
A balance sheet is a document that specifies a company’s assets and liabilities. Liabilities can be categorized either as debts or equities.
Balance sheets are one of the four key financial statements construction contractors must use to manage their books. The other three are the Income Statement, the Cash Flow Report, and the WIP (Work in Progress) Schedule.
Why Should I Keep One?
Provides A High Level Picture Of Financial Health
The simple calculations you make in order to 'balance' your books (hence the name balance sheet) will give you the information you need to assess your project and your company’s financial health, as well as a very high level 'Top Down' view of where your business currently stands financially.
Conversely, these critical statements can easily become unbalanced when you let them lapse or neglect to input certain assets or liabilities, and you can have an incorrect sense of where things stand.
Improves Planning For Future Projects
Because your main purpose is to turn a profit, your balance sheet is your best source of information when it comes to knowing if certain projects are viable and will ultimately yield a profit. It will give you an overview of what you own, what you expect to take in, and what you plan to pay-out.
Important For Investment And Financing
“Never invest in a company without understanding its finances. The biggest losses in stocks come from companies with poor balance sheets.”– Peter Lynch
To help your co-owners and your investors (including lenders) understand the finances of your company you must first ensure that your balance sheets are accurate and provide a good picture of where you are currently positioned from a financial perspective.
The Anatomy Of A Balance Sheet
A balance sheet has two key sections, a left and a right, that must balance. On the left we have the Assets, and on the right we have a combination of the Liabilities and the Owner's Equity.
Below is an example of a complete balance sheet and shows these left and right sections and the fact that they must balance (ie the bottom of the left must equal the bottom of the right).
Example Balance Sheet
| Ending Balance Sheet | |||
|---|---|---|---|
| Marcus Constructions, March 31 | |||
| Assets | . | Liabilities And Owner's Equity | |
| Cash | $70,500 | Accounts Payable | $45,000 |
| Accounts Receivable | $45,500 | Notes Payable | $20,500 |
| Inventory | $20,000 | Retained Income | $25,000 |
| Prepaid Expense | $2,100 | Paid-In Capital | $47,600 |
| $138,100 | $138,100 |
Let's go deeper into these three segments.
Assets
An asset is defined as a resource or item that a company owns. In the asset section of your balance sheet, you will find current and long-term items owned by the company.
These can be used for future business activities or to manage a current project. Your asset section can therefore be further divided into two sub-categories: current assets and long-term assets.
Current Assets:
A current asset is the kind of item that can be used within one year, or one operating cycle, whichever is longer. A company can also liquidate these assets on short notice.
The best example of a current asset is cash. Another is the accounts receivable which cover any amount owed by someone else to the contractor.
Long Term Assets:
Long-term assets are the kind of items that can benefit the company beyond one operating cycle or one year. These are tangible items like vehicles, properties, equipment, or machinery. In the above example, the total assets are the sum of available cash, accounts receivable, inventory, and prepaid expenses which is $138,100.
Liabilities
Liabilities are the opposite of assets. They are economic obligations owed by the company and will need to be settled in the future. Like assets, liabilities can also be current or long-term.
Current liabilities need to be settled within a year or one operating cycle, whichever comes last.
A good example of a liability is your accounts payables. This is the amount owed by the company for services or products provided. They can be current or provided in the future such as utility payments or staff salary dues.
Long-term liabilities are financial obligations that go beyond the operating cycle or are longer than a single year.
Outstanding loans are long-term liabilities. Let’s say your company takes out a loan from the bank to purchase equipment or machinery. Until this loan is paid off, the bank will have a claim on this asset.
The bank claim therefore represents a liability to your business. In addition, any deferred income taxes are also long-term liabilities.
In the above example, the total liabilities are the sum of your notes payable and accounts payable, which is $65,500.
Equity
Simply put, equity is the difference between the company’s assets and its liabilities. Equity is made up of three main components: paid-in capital, retained income, and distributed income.
If you consider the example above, this amount would be $72,600 ($138,100 - $65,500).
The paid-in-capital is what the contractor invested into the company, either from their own savings or from any other sources. The retained income is the net income that a company decides to keep. After paying out dividends, the excess or the profit continues to accumulate and gets reinvested into the business.
And finally, the distributed income represents the profits that could potentially be distributed among corporate owners or withdrawn by private owners.
So in summary, the formula for calculating Equity is as follows:
Equity = Assets - Liabilities
Building A Balance Sheet: Some Practical Examples
Now that we know why Balance Sheets are so important and why we need to use them, let’s consider the best practices for building one.
The first step is to define the transactions.
When construction begins, all kinds of expenditures are incurred, starting from construction materials like bricks, screws, and planks, to the salaries of workers. All of these expenditures are classified as transactions.
At this stage, you can use a transaction sheet to keep track of all of these expenditures.
Each expenditure should be clearly defined, named, and considered as a transaction. The Balance Sheet represents the sum of these transactions incurred during a specific period as the construction is happening.
The lifecycle of each transaction can change from job to job but will always either result in an addition or a subtraction to the assets or liabilities of the owner’s equity. Make sure to move each of the transactions from one section to another when needed in order to keep the sheet balanced.
If this all still sounds a bit technical and vague, here are a few practical examples to help you see that it's actually quite straightforward:
Example 1: Making Payments for Materials
Markus Construction needs to purchase cement, planks to stucco, and paint to build a new house.
Transaction Sheet 1 (Before materials are used)
| Assets | Liabilities & Owner's Equity | ||
|---|---|---|---|
| Cash | $180,000 | Accounts Payable | $140,000 |
| Accounts Receivable | $150,000 | Notes Payable | $80,000 |
| Inventory | $20,000 | Paid-in-capital | $25,000 |
| Prepaid Expense | $5,000 | Retain Income | $10,000 |
| $255,000 | $255,000 |
The company makes a payment of $10,000 to purchase materials. They use their cash assets, which were $180,000, to pay.
In this case, after this transaction, $10,000 is deducted from the cash assets which become $180,000 - $10,000 = $170,000.
You would then add the same amount to the inventory assets column and wait for the materials to be used for the project.
The inventory will be $20,000 + $10,000 = $30,000, until it is consumed.
Finally, when the materials have been consumed, they can be deducted from both the inventory and the owner’s equity (specficially from the Paid-in-capital section).
Transaction Sheet 2 (After materials are used)
| Assets | Liabilities & Owner's Equity | ||
|---|---|---|---|
| Cash | $170,000 | Accounts Payable | $140,000 |
| Accounts Receivable | $50,000 | Notes Payable | $80,000 |
| Inventory | $10,000 | Paid-in-capital | $5,000 |
| Prepaid Expense | $5,000 | Retain Income | $10,000 |
| $235,000 | $235,000 |
As a result, you can see the values of the assets and equity have changed in the new balance sheet amounts.
More specifically, Cash has reduced by $10,000 (as they spent it on the materials), and Inventory has also reduced by $10,000 (as they used the inventory)
Because these outgoings reduced the left hand side of the equation by $20,000, this is reflected in a $20,000 decrease in the right bside to balance, so it is removed from the Paid-in-capital
Example 2: Borrowing Money for Payroll
Markus Construction has twenty employees and pays their salary with a bank loan of $30,000.
This type of transaction happens whenever a company borrows money to finance a project. They will need to add these amounts to the notes payable and cash assets categories.
Building from the example above, here is how the new balance sheet would look.
| Assets | Liabilities & Owner's Equity | ||
|---|---|---|---|
| Cash | $200,000 | Accounts Payable | $140,000 |
| Accounts Receivable | $50,000 | Notes Payable | $110,000 |
| Inventory | $10,000 | Paid-in-capital | $5,000 |
| Prepaid Expense | $5,000 | Retain Income | $10,000 |
| $265,000 | $265,000 |
As we can see, the Cash value has increased by $30,000, and this has been balanced by an increase of $30,000 to Notes Payable.
It is important to remember that until the loan amount is paid off the lender will have a claim on this asset. Therefore, having it outlined in the balance sheet allows you to make the appropriate decisions and always keep this “liability” in mind.
Example 3: Receiving Payments From A Client
Whenever clients are billed, the amount is added to both Accounts Receivable and the Owner’s Equity section (as Retain Income). Any billing will result in better financial standing for the company which is why tracking it is so important.
Let's see how the balance sheet would look after a $50,000 invoice is issued to a client.
| Assets | Liabilities & Owner's Equity | ||
|---|---|---|---|
| Cash | $200,000 | Accounts Payable | $140,000 |
| Accounts Receivable | $100,000 | Notes Payable | $110,000 |
| Inventory | $10,000 | Paid-in-capital | $5,000 |
| Prepaid Expense | $5,000 | Retain Income | $60,000 |
| $315,000 | $315,000 |
As we can see, $50,000 has been added to Accounts Receivable on the left side, and balanced as an increase of $50,000 to the Retain Income value on the right.
Now let's look at the same sheet once the client pays the invoice.
| Assets | Liabilities & Owner's Equity | ||
|---|---|---|---|
| Cash | $250,000 | Accounts Payable | $140,000 |
| Accounts Receivable | $50,000 | Notes Payable | $110,000 |
| Inventory | $10,000 | Paid-in-capital | $5,000 |
| Prepaid Expense | $5,000 | Retain Income | $60,000 |
| $315,000 | $315,000 |
As we can see, the difference is that $50,000 has simply moved from Accounts Receivable to Cash.
Using Balance Sheets To Determine Financial Health
As we mentioned above, in conjunction with income statements and cash flow reports, Balance Sheets are used to assess your company’s financial health.
They are also referred to by third parties such as lenders and insurers to establish whether or not the company presents a credit risk.
There are four key metrics used to calculate financial soundness by using a balance sheet:
1. Working capital turnover
2. Current ratio
3. Equity turnover ratio
4. Debt-to-equity ratio
1. Working Capital Turnover
Your working capital turnover (WCT) measures how your ** Working Capital** is being used to generate profits for the company over time.
In order to understand WCT, we first have to understand what Working Capital is.
According to Investopedia:
Working capital, also known as net working capital (NWC), is the difference between a company's current assets, such as cash, accounts receivable (customers' unpaid bills) and inventories of raw materials and finished goods, and its current liabilities, such as accounts payable.
Now we know what Working Capital refers to, we can apply the following formula in our calculation in order to understand the amount of WCT:
WCT = Net Sales or Revenue ÷ Working Capital
Example of a WCT calculation over two years, 2019 and 2020:
| Year | Net Sales (in million $) | Average Working Capital (in million $) | Working Capital Turnover (WCT) |
|---|---|---|---|
| 2019 | 2.4 | 1.1 | 2.18 |
| 2020 | 2.7 | 1.2 | 2.25 |
In this example we can see that the WCT improved slightly year on year, from 2.18 to 2.25. This means that the company is doing a slightly more efficient job of turning working capital into profits, which would be considered a good sign regarding the company's financial health.
2. Current Ratio
The Current Ratio, also known as the working capital ratio, is a metric used to assess if a company can pay its current short-term obligations with its current assets.
This ratio reflects the ability of a company to generate enough cash to pay off its debts when they are due.
It is also a ratio that reflects the company’s aggression with regards to investing its assets in generating profits. I.e a low ratio would indicate a more aggressive approach, investing a lot of what it has on hand in generating profits, whereas a higher ratio would indicate a more cautious approach.
The formula to calculate your current ratio is:
Current Ratio = Current Assets ÷ Current Liabilities
When it comes to the construction industry specifically, there exists what is considered an 'ideal' Current Ratio between 1.20 and 1.60.
A lower-than-average score could mean a high risk of defaulting which is concerning to third party institutions.
A higher-than-average ratio could mean there is inefficient use of your assets (i.e. you are maybe not investing enough of them). This could help you in the decision-making process as far as spending is concerned.
Here is an example of current ratio calculation for the years 2019 and 2020:
| Year | Current Assets (in million $) | Current Liabilities (in million $) | Current Ratio |
|---|---|---|---|
| 2019 | 8.1 | 5.0 | 1.62 |
| 2020 | 8.0 | 5.2 | 1.53 |
If we look at these results, we see the Current Ratio for this business decreased from 1.62 to 1.53. As we mentioned before, a ratio higher than 1.6 would be considered problematic for the reason that assets are not being used as they could be to generate profit.
If we consider that the ratio decreased to 1.53 which is considered in the desirable range, we can correlate this to the fact that our WCT increased slightly over the same period from 2.18 to 2.25. In other words, the company is using slightly more of its assets, but this has been more effective in generating profit.
This metric can also be used to compare the financial health of different companies in the same industry. This could help situate the company within the context of the broader industry, which is very useful information especially for third parties evaluating your company, as well as for your own sense of where your company lies.
3. Equity Turnover Ratio
The Equity Turnover Ratio (ETR) measures the efficiency with which a company is using its shareholder equity to generate revenue. In this manner it is very similar to the WCT, however where the WCT used Working Capital overall, the ETR focuses specifically on usage of shareholder equity.
The following formula is used to calculate your equity turnover:
Equity Turnover Ratio = Total Revenue ÷ Average Stockholders' Equity
Example of calculation of equity turnover for 2019 and 2020:
| Year | Net Sales (in million $) | Total Shareholder Equity (in million $) | Equity Turnover Ratio |
|---|---|---|---|
| 2019 | 2.4 | 0.9 | 2.67 |
| 2020 | 2.7 | 0.9 | 3.0 |
A high equity turnover ratio indicates that shareholders’ equity is being used efficiently, so in this case we can see the company is improving its ETR from 2.67 to 3.0 year on year.
Equity holders in the company should be happy with this result.
4. Debt-to-Equity Ratio
Debt-to-equity ratio is used to evaluate a company’s financial leverage. A high Debt to Equity Ratio means that a company is being supported by creditors rather than equity.
For this reason, this ratio is particularly important to potential investors or further lenders.
The formula for this calculation is as follows:
Debt-to-Equity Ratio = Total Liabilities ÷ Total Equity
Let's look at our example company again:
| Year | Total Liabilities (in million $) | Total Shareholder Equity (in million $) | Debt-to-Equity Ratio |
|---|---|---|---|
| 2019 | 2.25 | 0.9 | 2.67 |
| 2020 | 1.9 | 0.9 | 2.11 |
The higher the debt-to-equity ratio is, the greater the risk the creditors are assuming.
When it comes to construction companies, a ratio of three or lower is generally considered acceptable, so this company's debt-to-equity ratio shouldn't raise too much concern.
Summary Of Using Balance Sheets For Financial Health And Modelling
As you can see, different calculations can be helpful is figuring out how the company is performing, how sound the project planning is, and whether changes or revisions need to be made in the long term.
Balance sheets are a great way to demonstrate a construction company’s liquidity for example. They help us understand how capable a company is of paying its bills on time and how efficient it is at doing so.
Although a balance sheet is generally run at the end of a pre-determined financial period such as quarterly or yearly, it can also be produced as needed. This would provide a snapshot of a company’s financial situation at any point in time.
Common Mistakes And How To Avoid Them
Something to consider when applying these example is that people sometimes make mistakes when they enter information into the balance sheet.
When building your balance sheet, there are four common mistakes you will need to avoid. These include confusing liabilities with assets, forgetting to add a transaction, not tracking inventory properly, and making transposition errors.
1. Not putting transactions in the right category on the sheet
As mentioned earlier, liabilities are what the contractor owes to someone else, and assets represent what you are owed and what you own. While entering a transaction into the balance sheet it is really important to draw a clear line between these two items. It is very easy to confuse them and make the entry in the wrong section.
Remember that the sheet always needs to balance, so when a transaction represents something on one side, it must represent a corresponding value on the other side. For example in the case of a bank loan, there is an increase in Cash on the left side, and this must be balanced by an increaase in Notes Payable on the other side.
To avoid this error, make sure to pay close attention to and understand what each transaction actually represents before entering it into the sheet. It may help to do a quick Google search if you are confused about a particular transcation and where it belongs.
2. Missing transactions
Missing just a single transaction can throw your balance sheet off completely. It is very easy to think that you will make the entry later, and then forget to do it. You can also forget either the transaction itself or the amount. This can happen to anyone.
To avoid this common mistake, you should carry a pen and pad and make note of the transaction as soon as you become aware of it. Make it a habit of entering these items into the balance sheet the first chance you get.
3. Not tracking inventory properly
At the end of each task, the inventory usage must be updated by the project leader. And you should tally it against what has been reported by the project leaders.
If you forget to track the inventory used for each task, this will throw off your balance sheet. To avoid the discrepancy, note the inventory items used after each task on your pad and update the sheet as soon as you have time.
4. Transposition Errors
When entering several transactions at the same time into your balance sheet, you might sometimes inadvertently invert the numbers or make a typo. For example, if there is a transaction of $4,500, you might invert 45 to 54 and make the entry as $5,400. Or you may add an extra 0 accidentally and make it $45,000! These kind of typos actually happened to me while I was writing this, it's easy.
That’s why it is good to have a coworker help you with an extra set of eyes by reviewing your balance sheet and ensuring the numbers are correct.
Final Takeaways And Tips
The rule of thumb here is that when building your balance sheet, you should always remember to balance each transaction from left to right. Every transaction can result in a change in the assets or liabilities, and this can affect the owner’s equity.
Using a pad and pen, regularly updating your balance sheet when new transactions have occurred and having an extra set of eyes to check your work are excellent best practices.
After all the transactions have been entered into the balance sheet over a period of time, they can be added up as the closing balance. This can later be transferred to a new balance sheet.
We hope this was informative and useful for you and your business. We want to keep expanding this resource over time, so feel free to add comments below and let us know if you think we've missed something.
Thanks a lot for reading.
