Business Finances & Accounting

Business finances and accounting questions are among the most numerous on the Law & Business exam, and most of them reward a candidate who knows a handful of definitions and formulas cold. This topic covers how contractors keep books, read financial statements, calculate the key ratios, and finance the gap between paying for work and getting paid.

Accounting methods

Two basic methods come up repeatedly, plus two ways to recognize revenue on long jobs.

Strict cash-basis accounting is not recommended for contractors because it does not match income with expenses and records neither receivables nor payables. Under percentage of completion, if a year’s work represents 50 percent of total contract performance, then 50 percent of the estimated revenue and profit is considered earned. For federal income tax purposes, the accrual method is required whenever inventories are used.

The two financial statements

The balance sheet is a snapshot of the business at a single point in time. Assets sit on one side; liabilities and equity sit on the other. Assets are listed in order of declining liquidity, where liquidity is the speed with which an item converts into cash. Current assets are those convertible to cash within one year; current liabilities are debts due within one year and are usually paid from current assets.

The income statement summarizes revenue, expenses, and the resulting profit or loss over a period of time. Operating profit is revenue minus total cost of operations, before federal income taxes. “Bottom line” in the law book means net profit. For most contractors, materials used is the single largest expense item.

Ratios and working capital

A ratio is the relationship between any two figures in the current financial data. The current ratio and quick ratio both measure liquidity, the ability to pay debts when due. The quick ratio is more conservative because it counts only quick assets that are readily converted to cash.

Example: with current assets of $250,000 and current liabilities of $180,000, the current ratio is 1.39. With quick assets of $140,000 against the same liabilities, the quick ratio is 0.78.

Long-term creditors watch the ratio of total liabilities to net worth, which shows how much of the contractor’s assets are supplied by creditors versus owners.

Taxes and business form

For a sole ownership or partnership, business income is reported as personal income on the owner’s return, and estimated federal and state income taxes are paid quarterly. An S corporation operates in corporate form but is taxed like a partnership. The State Board of Equalization can require a deposit of estimated sales tax for the first six months. A contractor must collect sales tax from the customer unless the tax on materials was already paid at the time of purchase.

Financing the cash gap

Contractors need extra capital because of the timing difference between when they must pay and when they get paid. Retention is a particular drain: it usually exceeds profits and is not released until the total project is accepted, so the problem is worst for a subcontractor who finishes early.

The two types of external financing are equity funds (investors gain some control and a share of profits, and the money stays in the business) and debt (borrowed dollars repaid with interest, with the owner not normally giving up control). For short-term working-capital needs, a contractor can set up a line of credit. The SBA typically guarantees repayment of a loan rather than lending directly. Lenders evaluate Character, Capacity, and Certainty, and financial reports that meet professional standards should be prepared by a certified public accountant.