CENG 6108 Construction Economics

Understanding Financial Statements

Abraham Assefa Tsehayae, PhD

May, 2017

Abraham Assefa Tsehayae 1/24

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TO
DO
① Financial Statements:
• Income Statement

• Balance Sheet

② Financial Ratios

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Introduction:

In all businesses, including construction industry,

financial statements are important for reflecting the
financial health of a company.
The two most important financial statements:
1) Income Statement (or called Profit and Loss Account)
2) Balance Sheet.
Income Statement
Shows the profit made or the loss incurred by a company in
a period of time (usually one year)
Usually two consecutive years of the following information
are shown:
• Revenue
• Costs
• Other expenses

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 Period (one year) ended

on 31/12/2012 31/12/2011

Revenue 40,185,000 38,483,000

Cost of Revenue

Materials 13,000,000 12,500,000

Labour 5,500,000 5,400,000

Subcontracts 12,500,000 12,000,000

Other direct costs 1,087,000 1,085,000

Total Cost of Revenue 32,087,000 30,985,000

8,098,000 7,498,000
Income Statement Gross Profit Operating Expenses
Variable overhead Fixed

overhead 2,036,500 1,943,500

Total Operating Expenses 3,358,500 2,979,500

Operating Profit 5,395,000 4,923,000

Other Income/Expense 2,703,000 2,575,000

Gain/loss on sale of assets

Miscellaneous income/expense 30,000 (38,000)

Interest income (5,500) 4,000

Interest expense 19,000 12,900

Total Other Income/Expense (42,500) (41,000)

Net Profit before Tax 1,000 (62,100)

Tax Expense (25% tax 2,704,000 2,512,900

rate) Net Profit after Tax 676,000 628,225

2,028,000 1,884,675

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Income Statement

Revenue:
First row of the income
statement Also means Sales or
Income
Represents the amount of money the company receives before (or
without) deducting any expenditures related to the company’s
revenue
Cost of Revenue
Is the direct construction/production cost, which the construction
company has incurred in order to earn the Revenue
Gross profit
Gross profit = Revenue – Cost of Revenue
Operating Expenses
Usually consist of Variable Overhead (e.g. advertising, plant,
equipment, vehicles, etc.) and Fixed Overhead (e.g.
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Income Statement
depreciation, rent, salaries, insurance, etc.)

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Income Statement

Operating Profit
After deducting the Operating Expenses from the Gross Profit,
we obtain Operating Profit.
Interest Expense
Is the interest payment on loan if a loan is borrowed by
the company.
Net Profit before Tax
Net Profit before Tax = Operating Profit - Total Other
Income/ Expense
Net Profit after Tax
Tax expense is calculated based on the countries tax law
(e.g., 27% for corporate tax in Ethiopia)
Net Profit after Tax = Net Profit before Tax – Tax Expense
This figure indicates whether or not the construction company’s
business is profitable.
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Balance Sheet

Shows a company’s financial position as at a point of time

(usually the last date of the company’s fiscal year)
There are three major items in a balance sheet:
1) Assets,
2) Liabilities, and
3) Equity (or called Net Worth).
1. Assets
Assets represent what a company owns, and are usually
presented at the top (first part) of a balance sheet.
Include two categories:
• 1.1) Current Assets
• 1.2) Fixed Assets

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 Balance Sheet
As at
31/12/2012 31/12/2011
Assets
Current Assets
Cash 2,589,000 1,967,890
Accounts receivable 5,767,000 5,403,670
Retention money 1,641,750 1,350,918
Material Inventory 850,000 520,000

Costs and estimated earnings in excess

547,250 450,306
of billings on work in progress

Prepaid expenses and others 894,500 983,944

Total Current Assets 12,289,500 10,676,728
Fixed assets
Property and equipment 15,536,900 13,800,000

Construction plant 2,680,040 2,039,480

Vehicles/Trucks 2,070,000 1,812,000

Balance Sheet Furniture and fixtures

Total depreciable assets
345,000
20,631,940
379,000
18,030,480

Less accumulated depreciation 12,529,373 11,158,000

8,102,567 6,872,480
Net Fixed Assets
20,392,067 17,549,208
Total Assets
Liabilities
Current Liabilities
4,325,250 4,773,240
Accounts payable
1,586,037 1,475,918
Accrued expenses
647,250 491,973
Notes payable
919,380 756,514
Retention money payable
Billings in excess of costs and estimated 617,205 678,922
earnings on work in progress
355,713 292,699
Other current liabilities
8,450,835 8,469,266
Total Current Liabilities
3,528,557 3,695,267
Long-term Liabilities
11,979,392 12,164,533
Total Liabilities
Equity (i.e. Net Worth)
3,500,000 2,500,000
Capital stock
1,000,000 1,000,000
Additional paid-in capital 3,912,675 1,884,675
Retained earnings 8,412,675 5,384,675
Total Equity 20,392,067 17,549,208
Equity + Total Liabilities

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Balance Sheet

1.1. Current Assets:

Include usually cash, accounts receivable, construction
material inventory and so on which have high liquidity (i.e. can
be turned into cash easily).
1.2. Fixed Assets, also called Long-term Assets:
Include usually property and equipment, construction plant, trucks
and so on which cannot be readily turned into cash in a short
time.
2. Liabilities
Liabilities represent the obligations the company owes to some
third parties, and are usually presented at the middle part of a
balance sheet.
Include two categories:
• 2.1) Current Liabilities
• 2.2) Long-term Liabilities

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Balance Sheet

2.1. Current Liabilities:

Include bank overdraft and short term bank loan, accounts
payable to subcontractors, suppliers and employers, rents,
utilities and etc.
They are debts the company has to pay, say, within a year.
2.2. Long-term Liabilities:
Are obligations with a period more than one year, usually a
few years or even longer.
Include long term bank loans or loans for mortgages of
equipment, building, land, or even cars/ trucks. Such long-term
debts are usually repaid by installments.
3. Equity or Net worth:
Equity is the capital invested by the owner(s) of a company.
If the companies are owned by Stockholders, it will be referred to
as Stockholders' equity.

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Balance Sheet
• = Capital invested + Accumulated and Retained Profits (less
dividends paid so far to the owners)

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Income Statement

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Balance Sheet
The Accounting Equation:
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐸𝑞𝑢𝑖𝑡𝑦 + 𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
Balance Sheet, is in fact derived from the fact that the
three items must be in balance.
Working Capital and Current Ratio
Work Capital
• Refers to the difference of Current Assets and Current Liabilities:

• 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

• The amount of working capital in hand is a measure of the short

term financial strength of a construction company.
• Working capital increases when a company makes a profit on a
project, sells equipment or other assets, or has a long term loan from
a bank.
• A long term bank loan can increase current (short term) assets, but at
the same time increases long term liabilities.
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Balance Sheet
Working Capital and Current Ratio
Work Capital
• The volume of unfinished work of all projects in hand should be at
most about ten times the working capital for a construction company,
and not more than five times if there is large project.
• In shown example,
– The working capital is $2,207,462 (i.e. $10,676,728 – $8,469,266) as at
31 Dec 2011, and

– The working capital is $3,838,665 (i.e. $12,289,500 – $8,450,835) as at

31 Dec 2012.
Current Ratio
• Measures its ability to fulfill short term financial obligations:

• 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

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Balance Sheet
Working Capital and Current Ratio
Current Ratio
• Based on experience shown over a long period of time, the current
ratio for a construction company should be 1.3 or higher.
• In shown example,
– The current ratio is 1.26 (i.e. $10,676,728 / $8,469,266) as at 31 Dec 2011,
and
– The current ratio is 1.45 (i.e. $12,289,500 / $8,450,835) as at 31 Dec 2012.

Under Billing and Over Billing

Under billing is expressed in the balance sheet as “Costs and
estimated earnings in excess of billings on work in progress”
under Current Assets.

Over billing is expressed as “Billings in excess of costs and

estimated earnings on work in progress” under Current Liabilities.

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Balance Sheet
Under Billing and Over Billing
A construction company has the following project financial data:
Financial Data Amount ($)
Contract sum 8,000,000
Billed to date 4,700,000
Cost incurred (i.e. cost of revenue) to date 3,700,000
Estimated cost to complete 3,000,000

Up to the present moment, the percentage of completion

𝐶𝑜𝑠𝑡 𝑖𝑛𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑡𝑜 𝑑𝑎𝑡𝑒
• = 𝐶𝑜𝑠𝑡 𝑖𝑛𝑐𝑢𝑟𝑟𝑒𝑑 𝑡𝑜 𝑑𝑎𝑡𝑒L𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑐𝑜𝑠𝑡 𝑡𝑜 ∗ 100%
𝑐𝑜𝑚𝑝𝑙𝑒𝑡𝑒

$U,WXX,XXX
• = $U,WXX,XXXL$U,XXX,XXX ∗ 100% = 55.22%

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Balance Sheet
Under Billing and Over Billing
Revenue to date
• = 𝐶𝑜𝑛𝑡𝑟𝑎𝑐𝑡 𝑠𝑢𝑚 × % 𝑜𝑓 𝑐𝑜𝑚𝑝𝑙𝑒𝑡𝑖𝑜𝑛
• = $8,000,000 ∗ 55.22% = $4,417,600

Gross Profit to date

• = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝑡𝑜 𝑑𝑎𝑡𝑒 – 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝑡𝑜 𝑑𝑎𝑡𝑒
• = $4,417,600 − $3,700,000 = $717,600

Over billing
• = 𝐵𝑖𝑙𝑙𝑒𝑑 𝑡𝑜 𝑑𝑎𝑡𝑒 – 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝑡𝑜 𝑑𝑎𝑡𝑒
• = $4,700,000 − $4,417,600 = $282,400

If over billing is a negative value, then it is called under billing:

• 𝑈𝑛𝑑𝑒𝑟 𝑏𝑖𝑙𝑙𝑖𝑛𝑔 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝑡𝑜 𝑑𝑎𝑡𝑒 – 𝐵𝑖𝑙𝑙𝑒𝑑 𝑡𝑜 𝑑𝑎𝑡𝑒

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Financial
Ratios:
Financial Ratios help a lot in indicating the financial
health of a construction company.
Financial ratios relevant to the construction industry can
be classified into five categories:
3.1) Profitability Ratios,
3.2) Liquidity Ratios,
3.3) Working Capital Ratios,
3.4) Capital Structure Ratios, and
3.5) Activity Ratios.

3.1) Profitability Ratios

Profitability ratios measure the construction company’s ability
to earn profit from its operation.

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Financial
Ratios:
3.1) Profitability Ratios
The three most commonly used profitability ratios are:
Gross Profit Margin Ratio
• = 𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡 / 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
• = 8,098,000 / 40,185,000 = 20.15%
• The goal for net profit margin ratio is 25% minimum; if subcontractors
(pay-as-paid basis) occupy a significant portion of the cost of
revenue, the goal can be reduced to 20% minimum.
Net Profit Margin Ratio
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥
• = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
• = 2,704,000 / 40,185,000 = 6.73%
• The goal for net profit margin ratio is 5% minimum.
Return on Equity Ratio
• = 𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥 / 𝑂𝑤𝑛𝑒𝑟𝑠’ 𝑒𝑞𝑢𝑖𝑡𝑦
• = 2,704,000 / 8,412,675 = 32.14%
• The return on equity ratio should be between 15% and 40%.

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Financial
Ratios:
3.2) Liquidity Ratios
Shows the ability to pay its obligations as they come due, common
liquidity ratios are:
Current Ratio
• = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 / 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
• = 12,289,500 / 8,450,835 = 1.45
• The current ratio > 1.3 for a financially healthy construction company.
Acid Test Ratio (or Quick Ratio)
• = (𝐶𝑎𝑠ℎ + 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠) / 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
• = (2,589,000 + 5,767,000) / 8,450,835 = 0.99
• The acid test ratio or quick ratio > 1.1 for a construction company
Current Assets to Total Assets Ratio
• = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 / 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
• = 12,289,500 / 20,392,067 = 60.27%
• The current assets to total assets ratio should be between 60%
and 80%)

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Financial
Ratios:
3.3) Working Capital Ratios
Measure how well the construction company is utilizing its working
capital, common working capital ratios are:
Working Capital Turnover
• = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 / 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
• = 40,185,000 / (12,289,500 – 8,450,835) = 10.47 𝑡𝑖𝑚𝑒𝑠
• The working capital turnover should be between 8 and 12 times
per year
Net Profit to Working Capital Ratio
• = 𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥 / 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
• = 2,704,000 / (12,289,500 – 8,450,835) = 70.44%
• The net profit to working capital ratio should be between 40% and
60%
Degree of Fixed Asset Newness
• = 𝑁𝑒𝑡 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑏𝑙𝑒 𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠 / 𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑏𝑙𝑒 𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠
• = 8,102,567 / 20,631,940 = 39.27%
• The degree of fixed asset newness should be between 40% and 60%
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Financial
Ratios:
3.4) Capital Structure Ratios
Indicate the ability of the construction company to manage
liabilities, common capital structure ratios are:
Debt to Equity Ratio
• = 𝑇𝑜𝑡𝑎𝑙 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 / 𝑂𝑤𝑛𝑒𝑟𝑠’ 𝑒𝑞𝑢𝑖𝑡𝑦
• = 11,979,392 / 8,412,675 = 1.42
• The debt to equity ratio should be lower than 2.5
Leverage
• = 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 / 𝑂𝑤𝑛𝑒𝑟𝑠’ 𝑒𝑞𝑢𝑖𝑡𝑦
• = 20,392,067 / 8,412,675 = 2.42
Or
𝑇𝑜𝑡𝑎𝑙 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 L 0|𝑛𝑒𝑟𝑠’ 𝑒𝑞𝑢𝑖𝑡𝑦
• = 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 / 𝑂𝑤𝑛𝑒𝑟𝑠’ 𝑒𝑞𝑢𝑖𝑡𝑦 = 0|𝑛𝑒𝑟𝑠’ 𝑒𝑞𝑢𝑖𝑡𝑦
• = (𝑇𝑜𝑡𝑎𝑙 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 / 𝑂𝑤𝑛𝑒𝑟𝑠 𝑒𝑞𝑢𝑖𝑡𝑦) + 1
• = 𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 + 1
• = 1.42 + 1 = 2.42
• The leverage should be lower than 3.5
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Financial
Ratios:
3.5) Activity Ratios
Indicate whether or not the construction company is using its
assets effectively, and if yes, how effective they are,
common activity ratios are:
Average Age of Material Inventory
• = (𝑀𝑎𝑡𝑒𝑟𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 / 𝑀𝑎𝑡𝑒𝑟𝑖𝑎𝑙𝑠 𝑐𝑜𝑠𝑡) × 365 𝑑𝑎𝑦𝑠
• = (850,000 / 13,000,000) × 365 = 23.87 𝑑𝑎𝑦𝑠
• The average age of material inventory should be shorter than 30 days
Average Age of Under Billings
• = (𝑈𝑛𝑑𝑒𝑟 𝑏𝑖𝑙𝑙𝑖𝑛𝑔𝑠 / 𝑅𝑒𝑣𝑒𝑛𝑢𝑒) × 365 𝑑
• = (547,250 / 40,185,000) × 365 = 4.97 𝑑𝑎𝑦𝑠
• The average age of under billings should be the shorter the better
Average Age of Accounts Receivable
• = (𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 / 𝑅𝑒𝑣𝑒𝑛𝑢𝑒) × 365 𝑑
• = (5,767,000 / 40,185,000) × 365 = 52.38 𝑑𝑎𝑦𝑠
• The average age of accounts receivable should be shorter than
45 days
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Financial
Ratios:
3.5) Activity Ratios
Cash Conversion Period
• = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑔𝑒 𝑜𝑓 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 +
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑔𝑒 𝑜𝑓 𝑢𝑛𝑑𝑒𝑟 𝑏𝑖𝑙𝑙𝑖𝑛𝑔𝑠 + 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑔𝑒 𝑜𝑓 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
• = 23.87 + 4.97 + 52.38 = 81.22 𝑑𝑎𝑦𝑠
• The cash conversion period should be shorter than 75 days

Average Age of Accounts Payable

• = [𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 / (𝑀𝑎𝑡𝑒𝑟𝑖𝑎𝑙𝑠 + 𝑆𝑢𝑏𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡𝑠)] × 365 𝑑
• = [4,325,250 / (13,000,000 + 12,500,000)] × 365 = 61.91 𝑑𝑎𝑦𝑠
• The average age of accounts payable should be shorter than 45 days

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Financial
Ratios:
3.5) Activity Ratios
Average Age of Over Billings
• = (𝑂𝑣𝑒𝑟 𝑏𝑖𝑙𝑙𝑖𝑛𝑔𝑠 / 𝑅𝑒𝑣𝑒𝑛𝑢𝑒) × 365 𝑑
• = (617,205 / 40,185,000) × 365 = 5.61 𝑑𝑎𝑦𝑠
• Usually there is no guideline on average age of over billings

Cash Demand Period

• = 𝐶𝑎𝑠ℎ 𝑐𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑
• – 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑔𝑒 𝑜𝑓 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 – 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑔𝑒 𝑜𝑓 𝑜𝑣𝑒𝑟 − 𝑏𝑖𝑙𝑙𝑖𝑛𝑔𝑠
• = 81.22 – 61.91 – 5.61 = 13.70 𝑑𝑎𝑦𝑠
• The cash demand period should be shorter than 30 days

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References:

Construction Financial Management, Tang, bookboon, 2014.

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