Financial Basics For Contractors
Originally published: 03.01.07 by Skip Snyder
Five crucial measures of a sound company.
Do you believe that growing your company will result in greater profits, a higher selling price, and an easier lifestyle? The reality is, these things won't happen — despite growth — if you don't understand and act upon some basic financial knowledge about your company. Based on the number of contractors I've spoken to over my many years in the hvacr business, flat performance is not a good thing. That's why I am so passionate about contractors learning financial basics and am one of the contractors who teach a series of classes called Financial Management 101 offered through Air Conditioning Contractors of America (ACCA).
I'd like to dispel a common myth about business finances and share with you some basic rules and formulas that I think any business owner must solidly understand.
Right now, some of you are thinking: "My CPA can analyze my financials and provide good advice." Here's why this is a myth: Your CPA has a different risk tolerance than you. Basing your decisions on your CPA's interpretation of your financials could result in missed opportunities. Most CPAs I've known have been very moderate risk-takers, and they lean to the rather-safe-than-sorry philosophy.
You, the hvacr contractor, the entrepreneur, the risk-taker, need to understand the basics of return-on investment, factoring in the risk/reward ratio and understanding what you were doing last year and what you need to do differently this year.
I have identified five crucial measures of a financially sound company:
1. How You Finance Your Business
Most of us have monies owed to us in our accounts receivable. We also need to meet payroll, pay our vendors/suppliers, and pay ourselves. Where does this cash come from? How are we going to finance our business — especially if we are growing?
Common sources include selling stock and negotiating lines of credit with banks; unfortunately, not paying our vendors on time and not paying ourselves an adequate salary falls into this category, too. One debt that also goes unnoticed because it's mostly invisible is a return on investment for the investment in time, money, sweat equity, and guarantees you gamble on the venture.
How you finance your business has a direct impact on your long-term success or failure. If people are calling you for money, your corporate credit cards are maxed out, and you barely take home enough money to support your family, then your finances are in trouble. Only with good business practices will you be able to pay your vendors with discounted values, pay yourself an adequate salary, and also receive some additional cash as a return on your investment. (Also, I believe your hvacr business creates an opportunity to leverage your banking relationships to invest in real estate. But that's another column for another time.)
I have a friend who has mastered how he finances his business. He operates a $1.5 million dollar residential service and replacement business. When you look at his balance sheet, his accounts receivable shows a "negative" figure — that's right, a negative figure. He is so aggressive in his invoicing and installation payment plan that he is prepaid for the majority of his installation and large repair work. Because I'm not a residential contractor, I was shocked at this, but he runs a tight ship and has an excellent reputation.
2. Cash In The Bank
With good business management and leadership, you can structure your marketing plans to gain a better relationship with your customers. One obvious win-win strategy is using maintenance agreements. I've seen many different maintenance programs. Some place what I consider to be an undue risk on the contractor but, as a very general concept, your maintenance agreement should accomplish two goals:
Ownership of your customer. Your maintenance agreement should put you in front of your customer when a problem occurs. You should be the first call. If not, revisit your agreement.
Generate working capital (cash) for your business. Your maintenance agreement should include a "prepayment" for future visits. Depending upon your structure, you can generate enough cash to operate your business for 10 to 30 days, depending upon the marketing concept. This is free cash that is injected in your company for you to invest. As our market changes, the need to "own our customer" will become a very critical strategy.
3. What You Pay Yourself and Your Employees
I was chairman of NATE from 2000 to 2003. I dedicated my time and money because of my belief that we need to raise the bar of professionalism in our industry; not just the technician but management and leadership, too. How can we expect to attract talent in this industry when some of us don't guarantee 40 hours a week for 52 weeks a year, vacation days, national holidays, and a health-benefit package? To me, this "I'll pay you when there's work" business concept is self-defeating. If we are striving to attract talent, we need to start from the top of our organization and work down. As a business leader, you need to change marketing strategies to give your employees a 40 hour workweek 52 weeks a year and pay them an adequate wage with benefits that is commensurate with competing industries. As the business leader, you should receive a weekly paycheck reflecting your talent, risk, and leadership skills. And as mentioned earlier and elaborated on later, you should receive that second payment for the investment in cash and guarantees you make to fund your business.
4. Discounting of Bills
With the drop in interest rates a few years ago, many of the 2%, net 10-day discounts disappeared, but with rising interest rates, they are making a comeback. This is easy money. It also makes a statement that you operate a well-funded business and are a good credit risk. With this reputation, vendors will come to you offering better deals. Missing these discounts is a cash loss to you and your organization.
5. Personal Guarantees To Lenders
I've had some pushback on this issue; however, I stand by my position that you should not personally guarantee loans to your business. I will concede that it took me 10 years to adequately fund my business before I went to the banks and asked that my personal guarantees be removed from business lines of credit and bonding. So let's start by saying if you have been in business over 10 years and still are personally guaranteeing your business lines of credit, you need to re-evaluate your business relationships and strategies. Banks are hungry for quality businesses. Leverage your business acumen, and stop guaranteeing your business debt. If you can't, then you need to re-evaluate the funding of your business. To attain these, you need to understand the cost of doing business and the dynamics of the marketplace.
Cost of Doing Business
There are a number of methods for determining the "cost of doing business" from annual volume per technician to revenues per truck. An interesting experiment would be to take your year-end financial statements, plug in the profits you desire, then calculate the number of billable days/hours per technician, including values for warranties and maintenance agreement exposures. Some of you may be surprised at the cost per hour of delivering a talented technician to the customer. Some contractors have different hourly rates for installation/contract work and service work. It will take some research, but the time invested is worthwhile. Once you find the actual cost per hour, you may want to challenge your competitor to do a similar exercise. Sharing formulas on calculating overhead is not a conflict with anti-trust issues. With this "cost to deliver" a talented technician, you will appreciate the damage done to your business by underbidding work and guessing at what you should be charging per hour.
Dynamics of the Marketplace
Do you compensate yourself for putting your personal assets at risk? What about the equity built up in your business or the time and worry in building and then operating the business? I'm not speaking about what shows up in your salary; instead, it's compensation for putting the business and personal equity at risk every day. What risk are you exposed to? Let me name a few: Lawsuits, pollution, discrimination, accidents (trucks/cars), accidents with system failures, carbon monoxide issues, customer bankruptcy, employee theft, workers compensation, and ever-rising health insurance.
Consider this: If you had $200,000 to loan to an hvacr business, and you calculated what your return should be based on the risk exposure for your investment, what would you expect annually? Compare this with putting the money in U.S. Treasury bonds or junk bonds. Should the return be 10%, 20%, or more? Some say the return should be close to 30%. So, you should be paying yourself a decent salary representing the work you provide; plus, the business also should pay you for the equity and guarantees you put at risk. If you have $200,000 at risk, the company should also be paying you 30% annually on that $200,000 above and beyond your reasonable compensation.
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Financial Basics For Contractors