Financial Management — Part 1

Quick, what's your average gross margin? When will your business break even? How much money did you spend on sales and marketing this year? How much money should you spend on sales and marketing next year? What's your debt ratio? When will you need to hire your next employee? When do you need to increase your credit line?

Did you have an answer for every question? Outstanding business owners can answer these questions and more — on the spot.

Most builders are passionate about building homes. However, most aren't very passionate about financial management. In fact, for any number of reasons and excuses, many builders allow other people to control their financial destiny.

You wouldn't drive your car by looking in the rear view mirror to see where you've been, would you?

Of course not, you look forward periodically checking behind you. That's the difference between accounting and financial management. Financial managers use accounting and operational statements to look at the past on a yearly, monthly, weekly, and sometimes even daily basis to try and improve on what they've learned from history and better steer the company moving forward.

It's great to have faith in your accountant because they can save you money at tax time and keep you out of trouble with Uncle Sam, but there's a big difference between managing the financial health of your company and preparing "the books." Besides, financial statements are only a portion of what you should look at as the financial manager of the company.

Make time. If you don't regularly review your financials, start by booking two hours a month in your calendar for review time and stick to it. A big reason business owners think they're too busy is that they continually repeat past mistakes. If prepared correctly, your financial statements are the road map to fixing any problem that can arise in your business.

A strong financial manager with industry experience can tell you if you've had quality problems, sales issues, construction delays, or any number of problems. They may not know the specifics of what happened, but they'll know there was a problem! If prepared correctly, every issue that happens in a business eventually shows up on your income statement or balance sheet and future articles will show how to recognize problems and take corrective actions.

Fortunately, you don't need to have a Ph.D., MBA, or a CPA to run an extremely successful and profitable building company. You only need a solid foundation of key financial principles that will start a lifetime of learning and improvement.

Many builders start building homes because their family built homes, or they were a framer, tradesmen, Realtor, or in some other part of our industry and thought, "Hey, I could do that." Unfortunately, as most builders find out, building a home is the easy part. There are many talented builders who don't survive because they never took the time to learn and understand what makes a company run well. So let's start at the beginning.

There are four main areas within any accounting system and they are:

• the chart of accounts
• the accounting method
• internal controls
• system documentation

Most people think of software when they think of an accounting system. However, there is more to an accounting system than software. Software is only a tool to aid in collecting and processing data and outputting reports. If not properly set up, your accounting system will not help you become an expert financial manager because of the GIGO principle (garbage in, garbage out).

Chart of Accounts:A chart of accounts is a systematic numbering structure for assets, liabilities, equity, income, cost of construction, and operating expenses. A chart of accounts includes accounts for:

• separate sales and costs of sales accounts (to record different types of work such as custom homes, speculative homes, remodeling activity, etc.)
• four main expense categories for
• indirect costs (building related costs that are not charged to specific jobs)
• sales and marketing
• finance
• general and administrative expenses
• detailed job cost accounts to account for direct costs of sales.

It's important to use a chart that is tailored specifically for our industry. The best chart is the NAHB chart of accounts, developed by industry experts and periodically updated. The most recent version can be downloaded free from NAHB.org [1].

Accounting Method:There are four different methods that are frequently used to recognize income, costs, and profits from construction activities: cash, accrual, completed contract and percentage of completion.

The percentage of completion method is the best method for small volume and custom builders and remodeling activities. Any speculative home activity should be recorded using the completed contract method, which is also the preferred method of accounting for larger volume builders.

The completed contract method of accounting only recognizes revenue when a job is finished and the home owner has gone to settlement. Larger volume builders use the completed contract method of accounting because they have several settlements per month and percentage of completion accounting becomes impractical.

For a small volume or custom builder however, completed contract accounting causes wild swings in earnings making it difficult (if not impossible) to effectively manage operations.

Percentage of completion accounting allows a smaller volume or custom builder to recognize a portion of revenues and the correlating portion of profit earned based on how much of a home or job is finished. Essentially, percentage of completion accounting smooths out earnings and alleviates the wild swings that a smaller volume builder would have were they to use the completed contract method of accounting.

Maintenance of a strong system of internal control is a key ingredient for a solid accounting system. The accounting system needs to be set up in a way to deter employees from intentionally or unintentionally misappropriating company funds.

Strong internal controls should provide a business owner with a level of confidence that:

• company goals and objectives will be met
• reliable financial reports will be produced
• effective and efficient operations are encouraged
• assets are protected
• compliance with laws and regulations is ensured

Some internal controls are:

• checks signed include supporting detail
• someone other than the person writing checks reviews bank statements
• change orders are reviewed for customer signatures
• periodic field reviews of jobs to ensure customers aren't receiving "extras"
• back up procedures for accounting data are in place and tested.

A system is only as good as the written documentation that goes along with it. Many builders re-invent the wheel when they loose a bookkeeper or accountant because they never wrote down the procedures of how things get done. The typical excuse is, "well, that person has been with me forever, they know what to do." That's great but what happens if that person quits or gets sick. If they've been with you for a long time, you may not even be aware of what they do.

Also, your trade partners need to be aware of how you operate. More than likely, you're not the only person they do business with. Make their life and yours easier by writing the procedures for submitting invoices or purchase orders and how you handle payments. Thanks to the World Wide Web, you can post these procedures on your web site.

You don't have to set up the system by yourself. As long as your accountant or bookkeeper understands what you're trying to do, they should be able to set up your accounting system for you. If you don't have a full time accountant or bookkeeper or you do your own books, hire professional help. Bottom line, find a way to make it happen.

The first and most important step to becoming the best financial manager you can — is to ensure the reporting system you'll be basing decisions on is set up properly. Setting the system up wrong is like playing baseball without a bat. You may get a hit every once in a while, but it's probably going to hurt.

The income statement is a summary of the:

• revenue — broken into subcate-gories of different revenue types such as:
• custom building
• production building
• speculative building
• remodeling
• etc.
• correlating direct costs — any costs that can be directly attributed to a specific job plus land if applicable.
• gross margin — any money left over after subtracting direct costs from the revenue
• expenses — broken into subcategories of:
• indirect costs
• sales and marketing expense
• finance expense
• general and administrative expense
• net income (earnings or loss) — any money left over after subtracting total expenses from the gross margin.

The income statement is a statement for a builder's operation for a specific time period such as for the month, quarter or year. Net income or loss for the period becomes part of the balance sheet by increasing (net income) or decreasing (net loss) the owner's capital.

For now, we'll stick with a simple year-end income statement. In future articles we'll examine some real life examples of income statements and how to interpret what they are telling you.

The first thing we need to analyze on any income statement is the amount and percentage of the costs of sales and the left over gross margin. Get used to looking at income statements as a dollar amount and a percentage amount. Understanding what both are telling you is important. You'll see why in later articles when we look at case studies.

The cost of sales as a percentage of sales is derived by dividing $75,000 (the direct cost of sales) by $100,000 (sales revenue) which is .75 or 75 percent. The gross margin is derived subtracting the cost of sales from sales, which is $25,000. The gross margin percentage is derived by dividing $25,000 (what's left over after direct costs) by sales $100,000, which is .25 or 25 percent.

The expenses as a percentage of sales are calculated the same way gross margin and direct costs as a percentage of sales. The total expenses percentage is the sum of all expenses divided by sales.

Net profit before taxes in this example is $11,000 and is what's left over after you subtract total expenses from the gross margin. The percentage of net profit from sales is — you guessed it, net profit divided by total sales that is .11 or 11 percent.

Many builders spend a lot of time and effort worrying about overhead expenses, which are certainly important. However, if your gross margin is low (meaning below industry benchmarks that range from, depending on builder type, 18 to 30 percent) or very low (meaning barely above your operating expenses) or worse, below operating expenses. Concentrate your efforts on improving gross margin. Here's why.

Let's say you build the same home 10 times a year with an average sales price of $100,000. Total sales for the year would be $1,000,000. Let's say that cost of sales (or direct costs) for each of those ten homes is exactly $80,000 for a total cost of sales of $800,000.

That leaves us with a gross margin of $20,000 per home or a total gross margin of $200,000. The gross margin percentage is 20 percent. (Gross margin dollars $200,000 divided by total sales of $1,000,000)

Let's also assume that operating expenses are exactly $140,000 or 14 percent. That leaves us $60,000 net profit before taxes or 6 percent net profit.

Now, since we have very limited time and resources, (remember, that's why we weren't spending any time reviewing financials in the first place) and we only have one day to spare during the year to work on improving our operations. Our choice of how to spend that day is to reduce operating expenses by $1,000 or reduce the direct costs of our one home plan by $1,000 through value engineering. Which one would you choose?

I hope you said to reduce the direct costs of our home plan. Here's why:

If we choose to spend the time to reduce operating expenses by $1,000, we'll have added $1,000 to our bottom line or increased our net profit margin by .01 percent.

If we choose to spend the time to reduce the direct costs of our home plan by $1,000, we'll have lowered our direct cost by $1,000 times the 10 homes we built during the year. Our new direct costs will be $790,000 and our new gross margin will be $210,000. Subtract our operating expenses of $140,000 and our new net profit margin is $70,000 or 7 percent. We've added $10,000 to the bottom line or an entire percent because of the multiplier effect.

Gross margin is everything in the homebuilding industry so if you're struggling to make your desired net profit, concentrate your efforts on improving your gross margin.