Construction companies operate in a highly competitive industry with tight profit margins. To be successful, they must maintain accurate financial records and have a thorough understanding of accounting principles. In this blog, we will discuss accounting for construction business, including the types of financial statements, accounting methods, and key performance indicators (KPIs) to track.
Types of Financial Statements:
Financial statements are the documents that provide an overview of a company’s financial health. Construction companies should prepare the following financial statements:
Balance Sheet:
A balance sheet provides a company’s financial status at a particular moment in time, giving an overview of its assets, liabilities, and equity. The balance sheet displays the assets owned by a company, the debts it owes, and the amount of equity held by the company.
Assets:
Assets include everything a company owns, such as property, equipment, and inventory. Liabilities are the debts a company owes, such as loans and accounts payable. The equity of a company is determined by subtracting its liabilities from its assets, which represents the net value or residual interest in the business that is owned by the shareholders.
Income Statement:
An income statement, also called a profit and loss statement, shows a company’s revenue and expenses over a specific period. The statement actively provides information about a company’s profitability and people use it to calculate net income.
Cash Flow Statement:
A cash flow statement shows how much cash a company has coming in and going out during a specific period.
Accounting Methods:
Construction companies can use one of two accounting methods: cash basis or accrual basis.
Cash Basis:
With cash basis accounting, revenue is recognized when cash is received, and expenses are recognized when cash is paid out. This method is simple but may not accurately reflect a company’s financial health because it does not account for outstanding invoices or bills.
Accrual Basis:
With accrual basis accounting, revenue is recognized when it is earned, and expenses are recognized when they are incurred. This method provides a more accurate picture of a company’s financial health but requires more complex accounting.
Key Performance Indicators (KPIs):
Metrics, which can be used to measure a company’s performance, utilize KPIs. Construction companies should track the following KPIs:
Gross Profit Margin:
The difference between the cost of goods sold and revenue, expressed as a percentage, is known as gross profit margin. A high gross profit margin indicates that a company is generating more revenue than it is spending on materials and labor.
Accounts Receivable Turnover:
Accounts receivable turnover measures how quickly a company is collecting payments from customers. If a company has a high accounts receivable turnover, it suggests that it is able to collect payments from its customers quickly and effectively, which is a sign of good financial health.
Days Sales Outstanding:
Days sales outstanding measures how long it takes a company to collect payments from customers. A low days sales outstanding indicates that a company is collecting payments quickly.
Job Profitability:
Job profitability measures how much profit a company is making on each job. A person calculates it by subtracting the cost of labor and materials from the revenue earned on a job.
Conclusion:
Accounting is essential for the success of construction businesses. Precise financial documentation not only offers an understanding of a company’s financial well-being but also aids in identifying opportunities for enhancement.
Construction companies should prepare financial statements, choose an accounting software, and track key performance indicators to stay competitive in the industry.
FAQ:
1. What is the most important financial statement for a construction business?
The most important financial statement for a construction business is the income statement, also known as the profit and loss statement. This statement provides information about a company’s profitability by showing its revenue and expenses over a specific period.
2. Why is accrual basis accounting more accurate than cash basis accounting?
Accrual basis accounting recognizes revenue when it is earned and expenses when they are incurred, regardless of when cash is received or paid out, providing a more accurate picture of a company’s financial health. This method also accounts for outstanding invoices and bills, providing a more complete view of a company’s financial position.
3. What is gross profit margin, and why is it important for a construction business?
After deducting the cost of goods sold, the gross profit margin represents the proportion of revenue that remains. For a construction business, this includes the cost of materials and labor. A high gross profit margin indicates that a company is generating more revenue than it is spending on materials and labor, which is essential for maintaining profitability.
4. What is accounts receivable turnover, and why is it important for a construction business?
Accounts receivable turnover measures how quickly a company is collecting payments from customers. For a construction business, this includes payments for completed projects. A high accounts receivable turnover indicates that a company is efficient at collecting payments, which is crucial for maintaining cash flow.
5. What is job profitability, and why is it important for a construction business?
Job profitability measures how much profit a company is making on each job. We calculate it by subtracting the cost of labor and materials from the revenue earned on a job. This metric is important for a construction business because it helps identify which jobs are most profitable and can inform decisions about pricing and resource allocation for future projects.