How HVAC Contractors Can Fix Bookkeeping and Understand Profit Before Going Broke - Ruth King

What's up? Welcome back to the business edition podcast where we talk about business in the trade. Now this one's a financial conversation myself in firm and we have Ruth King with us as a guest and she's a wealth and financial guru and she knows more than we do about it.

That's why she's our guest. She's been involved in that part of the industry for 40 years. Right. That's a long time. That's a lot of knowledge. That's a lot of built up education.

And we're going to ask her these questions and you guys are going to learn. So stick with us. This is the HVAC and all business edition with myself and firm and OEM HVAC parts and same day shipping. I know you guys can get in line with that now parts town delivers both of those.

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Welcome to the HVAC know it all podcast. Recorded from a basement somewhere in Toronto, Canada. Your host and HVAC tech Gary McCready will take you on a deep dive into the industry discussing all things HVAC from storytelling to technical discussion. Enjoy the show.

All right, Ruth King. Welcome to the business edition podcast with me and Gary. So happy you're here. I'm glad to be here. Thanks for having me. Welcome Ruth. Thanks Gary. Glad to meet you. Thank you. Yeah. Likewise.

I want to start by asking you, Ruth, when you look at a contractor's books for the first time, you're skimming through their financials. Where are the first things you look for?

First thing I look for is to make sure they're on a cruel basis, not a cash basis. Can you tell us the difference between those two? The difference is if you're on a cash basis, then you have no accounts receivable and no accounts payable.

And basically you have revenue when you actually get the money in not when you build it. And you have an expense when you actually pay the expense rather than when the expense comes in the doors of payable.

And so if you're on a cash basis, you have what a county financial statement, fruit salad, where is there you have revenue in the month, the money, you know, considered a sale in the months and then you have an expense, probably not in the same months because you probably didn't pay it exactly the same time.

And so you never know what your gross profit is, you never know what your profitability is. So that's why you have to be on a cruel basis, which means you have revenue when you send out an invoice, not when you get paid and you get accounts payable.

People vendors you own money to when the bills come in the door, not necessarily when you pay them.

I just sorry, I just wanted to ask a bookkeeper would be responsible for setting that up for you, right? Because most contractors are, I don't know how to do this, right?

So it's one button and book books literally a cruel from cash. It's not a big deal. Yeah, that's what I'm saying. A lot of contractors that are contractors now are just transforming to business owners. They don't know this stuff.

So the simple basic questions, I ask a lot because those are the questions that contractors are going to ask themselves. So firm and you can jump in.

No, it's great. I mean, next question Ruth would be, you know, there's the idea and I hear you talk about this all the time. And I want to hear about financially fit what you do, but I know that you need clean books to actually be able to leverage a lot of the cool tools you mentioned.

What does it mean for a contractor to have clean books? Like, how do I, if I was, if I'm at one truck or two trucks and I'm barely using QuickBooks today, how do I set up the right foundation there?

If you're a one or two truck operator, get a bookkeeper, you're better at generating revenue than actually doing your books. You should not have to learn how to do books. You should learn to question what the books say. So, you know, I work with one or two guys occasionally.

And I always get them bookkeepers, you know, ones that I necessarily trust to know to do the right job, the right way, not somebody who's their wife or their mother or their sister or their brother, unless they have a CPA over a bookkeeping background.

That would be the only alternative to that because they don't know any better than you do and they're going to learn it.

Give somebody, you know, who's gone to school. And let me pause you there. Like, how do you evaluate a good bookkeeper?

I've got the test. Somebody can send me give me an email. Let me an email. I'll give you happy to give you the test and answers.

Thank you.

Well, what's your email in here?

They're a good bookkeeper or I've worked with some for a long time too.

And I know ones that are really good at what they do. So the way I would look at that is I'd say, here's what you need to look at.

On your PNL, if you have negative gross profit, remember, it's revenue minus costs of goods sold is equal to gross profit.

And then subtract at your overhead to give you your net operating profit. So if you have negative gross profit, that means you have more expenses than you have revenue.

And generally what that means is you bought stuff, but haven't actually done the work and build for it yet.

I see this a lot with maintenance agreements when you make the sale so to speak in January or something like that for $200 and you count it as a sale, but it's not revenue to you.

It's a sale. The revenue comes when you actually do the work.

So, you know, that $200 should go into what's called deferred income and the savings account until you actually do the work.

And then when you do the work half of it comes out of deferred income into revenue and then you have the expenses against and then you do the second one.

So however many there are and divide that and then you have no more contingent liability. I know I'm getting into the weeds here, deferred income.

I've got a very simple question. Let's say you do sell maintenance contract. Let's simplify it. Let's say it's for a home and let's say it's four visits through the course of a year and that adds up to $1,000. Just make the numbers very easy.

Is it worth it for a contractor if they're able to to bill it up front, receive that cash upfront so their cash flow is moving? Is there any benefit to upfront billing so you have that cash upfront so you can use it in your daily cash flow.

If it's a thousand dollars, I would think twice about writing a check for a thousand dollars rather than doing it monthly.

It's still up front, but if we took a thousand dollars and we divided that by 50 instead of 52, okay. That's $20 a month. Let's say a thousand divided by 50. Let's do the math and make sure we're right. We're going to take a thousand dollars divided by 12 months. Oh, I was doing it by week. So it's 83 dollars a month.

So if we are looking at $83 a month, there are a thousand dollars. I'd rather pay the $83 a month, which is the key in most people's minds is it's not as big a thing.

If we can keep it under $20 a month or $30 a month depending upon where you are, then you're in a situation where most people don't even think twice about it.

And then they just do it on and on and on and on and on again. When you get into the 300, the 400, the 500, you know upfront, it's harder because people have to think about writing a check or giving you a credit card for that much money.

When it's little, you know, they just do it. So yes, you can still get it upfront, but I would do it if it's that much money. I would do it monthly rather than asking somebody to write me a check for a thousand dollars or give me a credit card for a thousand dollars.

Okay. And yes, maintenance is important. Keep doing it. Ruth, I want to go back to this question of clean books. You know, if I'm I know you've talked before about this trash in trash out problem where it's hard for someone to make sense of their financials.

If you don't have actually good data from the field, how did what's your advice to a contractor who's still trying to set up their operation there to make sure it's not trash in find somebody to do the books that knows what they're doing.

All right. So all they need to do is to give them the data i.e. What did we sell? I mean, what did we bill? What bills are in the door and not only have it done through their checking camp because in the beginning most contractors just give their bookkeeper access to the checking cap, then you want a cash basis rather than a cruel basis.

So we need to know what got billed need to know, you know, what came in the door with respect to payables. And as long as you can keep that pretty clean, the rest of the books should be pretty clean.

And who you know payroll can be done through quick books, it can be done through any number of different vendors who do payroll, I would suggest you also using that side source for payroll.

So it's actually safer believe it or not.

So I was trying to jump in, but it seems like there's a bit of a delay here. I wanted to ask a question regarding CRM. Again, from a contractor just starting out, they're probably going to want to use a CRM.

Now, they may not know that quick books and their CRM and all that can link, they can link up and the bookkeeper can can see all that visually to make it a lot easier for them to do so.

So I mean, you want to talk about that for a second, Ruth, about the CRMs and the quick books and how they link together and how that makes it easier for the bookkeeper to get all that information in.

So the CRM basically takes care of the dispatching part of it, the, well, it depends upon the CRM, what the CRM does. However, you know, most CRMs integrate either with quick books or with sage, one of the two, most smaller contractors are on quick books, they're not on sage.

You sage, you want sage intact because that's in the cloud.

So you want to make sure that you are having the two connected so that when you go out and do a service call or you go out and do an install or you sell a job or you put together for a puzzle or something like that, it's all in your CRM, whatever it is.

Then it follows itself through all the way through the completion of the job and the customer paying and then QuickBooks can every, you know, it's depending on how you set it up, it can be set up to batch once a day or continuous batch as things come in, they go into QuickBooks.

So yes, CRM is very helpful.

The question I was going to go to is around departmentalization, which is a big word, or the idea of creating separate departments on your PNL statement between, you know, most HVAC businesses have an install business and they have a service business.

Why is that important to like have two different PNLs?

Well, if you're a one truck guy or two truck guy, you're not going to have two different PNLs, you're not departmentalizing the only time you'll departmentalize is when you have field teams who only do service or field teams that only do install.

And the reason that you do that is the costing is different for those two types of work service is generally a higher overhead cost per hour than the install is so you're going to want to separate them and make sure both sides are profitable.

So when you get to that point, but if you're a one or two truck guy, maybe, you know, three trucks until you have somebody who's only doing service and never doesn't or, you know, rarely doesn't install and vice versa, you don't want to departmentalize doesn't make sense.

Got it.

Get your book first.

Yeah.

Yeah.

Got it.

So maybe when you're up at a million or a million and a half, two million, you have three or four trucks on the road, that's when it makes sense.

Yeah.

Probably.

Hmm.

Hmm.

What about another, another topic is around income and an owner as a, as an owner, you have a choice, right, which is to take an owner's draw or to pay yourself.

How should, as a new guy just starting out, how should someone think about that the difference because it's owners, but then I'm going to have to pay taxes.

Well, you're still paying taxes.

The reality of it is, if you make a profit, you're paying taxes, you can only fool, fool, I don't even want to use that word.

You only hide stuff for so long.

All right.

And the reality of the situation, you know, I have owners who say that when they sell their businesses, well, they're going to either pay the taxes when they sell the business, or they're going to pay the taxes when they, you know, actually take them every single year.

You should take a salary out of there.

You know, if your highest guy makes $30 an hour, your salary should be $31 an hour.

Take it out of there.

And, and because it's a legitimate business expense, it shows that you're operating, you know, soundly like a wise business person would do.

And then as the company grows, you can take a bonus later on.

Maybe.

Ruth, let me ask you a question.

Are you saying it's best to pay yourself, make yourself an employee of the company, rather than paying yourself like a dividend?

Yeah, absolutely.

Yeah.

What's the benefit of that over, like, what is the benefit of doing it as an employee rather than paying yourself a dividend?

First of all, at least in the US, the IRS is going to come after you for payroll taxes.

If you don't do it.

All right.

Okay.

I don't know what the Canadian rules are to be perfectly frank.

But I know in the US, the IRS frowns on looking at that.

If you show profitability, then you're going to be in a situation where they're going to see where the money is one way, shape or form.

But if you pay yourself the dividend, I mean, that's still recorded as personal income.

You're still going to pay taxes on it, regardless, right?

Curious as to what way would be more beneficial to the business and the person to the owner?

Pay yourself as an employee.

If you have any desire to grow your company, pay yourself as an employee and get used to it.

Because you will be paying employees.

You're going to end up paying yourself anyway.

You might as well start taking the PNL, the payroll that way.

If you want to pay yourself a dividend later on, because a business did very well, that's fine.

And it's not different types of businesses, depending upon the corporate setup, allow you to do that or don't allow you to do that.

So if you're a C corp, you're not, you know, you couldn't pay dividends, but you're paying it.

You're getting taxed down it twice.

So just FYI, that's important too.

Great. Now, let's maybe we can move next to like reading a PNL.

So again, we talked about how to make sure you get a good bookkeeper, make sure you put some foundational things in place.

So let's assume Ruth that a contractor comes to you and they actually have clean books.

What are the most important numbers?

You talk through gross margin and operating, gross profit and operating profit and the idea of overhead.

Can you just walk us through like, what are the most important numbers that a small HVAC business owner should be looking at when they're reviewing, when they're reviewing their PNL every month?

Well, first of all, they gotta be reviewing their balance sheet and every month because that's more important than their PNL.

Their most important ratio is actually working capital ratio and it's on your balance sheet.

So PNL start and stop, you know, you have a PNL from January 1st to January 31st and then it starts over again.

Your balance sheet never starts over again. It's a continuum.

So you take a snapshot on January 31st for its health February 28th.

So your business health is actually on your, on your balance sheet is not on your PNL.

Your balance sheet actually tells you whether your profitability is increasing or not, not your PNL.

PNL just tells you how you did for a certain period of time as it.

And you brought up the idea of working capital. How do you, how do you calculate that?

Working capital is current assets minus current liability.

A current asset is something that's cash returned into cash within a year, which is generally cash accounts receivable and inventory.

Prepaid expenses and then less there into large new construction projects, which we're not going there for now.

There are one or two truck guy and current liabilities are things that have to be paid within a year, generally your accounts payable, your credit cards payable, your taxes payable, stuff like that.

It's a practical and if the numbers increasing, your business is getting more healthy.

Your numbers decreasing your business is less.

So that's what I was going to ask you, Ruth, is you said the healthy your business is defined by your, your balance sheet.

So I was going to ask you how does this one determine that they're healthy or unhealthy.

And I think you just answer that.

And if you just want to confirm that if your balance sheet numbers continuously rising months to month, you're saying that that's a healthy,

it's a healthy way to look at it, right?

Yeah, it's not your balance sheet. It's your, you're working capital on your balance sheet.

Okay. Sorry.

So I got, I got.

Yeah. So working capital is current assets minus current liabilities. Okay.

So you want that always to be increasing the other ratio that you're going to want to look at is called the current ratio, which is

current assets divided by current liabilities. That's also a measure.

But those two will tell you health of your business more so than just about any other ratio that you could do on your balance sheet.

I love that you started here, Ruth, because sometimes I hear contractors talking about how profitable they are and obsessing about their profitability.

And unfortunately, I've seen some guys go out of business and they're highly profitable on paper.

But because to your point, they haven't thought about or managed their cash flow and they're working capital, they become insolvent.

Can you talk about the difference between cash flow and profitability?

Yeah, the two are totally different cash is on your balance sheet and profits are just revenue minus expenses.

And this is what happens. So let's assume that we have two jobs, each of them is $10,000 and we want a 20% net on the two jobs, okay.

So they each net $2,000 on the job, one of them took 40 hours and the other one took 100 hours or let's say 20 hours.

Let's make it easy.

So if we're netting $2,000 and we have 40 hours to do that job, that was $50 an hour net profit.

If we have $2,000 and 20 hours, we have $100 net profit per hour.

So which would you rather be? It's not the percentage profitability. It's actually the dollars.

How much every billable hour drops to the bottom line.

And if they're the same 20%, you know, who cares was the dollars that actually fell to the bottom line.

Do you want to be a $50 guy? You want to be a $100 guy? I'd be a $100 guy.

Maybe another way to put it is you could go out and do a $100,000 job, right?

Huge amount of revenue, but you don't collect on it for six months.

And another guy in that same time only does half the amount of revenue, but he clicks on it.

Well, the first guy, he may actually never be able to make payroll because he never clicks on that revenue.

And so despite how profitable you look on paper, you're not going to pay yourself or your guys and you got a business.

And so this is, I think, such an important and underappreciated point in this industry.

Here's what has to happen. You have to have positive profitable cash flow, which after you pay your bills turns into cash.

I mean, how many guys do you know have all this cash in the bank in the summertime when it's really, really busy when they go to pay their bills in the fall.

All of their money is used up and they have nothing to make it through the fall.

That means that they didn't have profitable cash flow.

I mean, I worked with the contractor years ago who grew from zero to $2 million.

And I'm back in the day when $2 million was really a lot of money.

And never looked at anything but their bank statements.

So if the long as they had money to pay their bills, take their discounts and do what they want, they were happy campers.

And then they hit $2 million in growth stopped.

So they started having problems occasionally making payroll and not taking their discounts.

And it's like, wait, we've never had this problem before.

So they were smart enough to call me on a phone and figure out what was going on.

And long story short, they were losing a nickel for every dollar they took in the door for 12 years.

And growth masks a lot of things because the cash flow from one jobs, which starts the next job.

And as long as you're growing, it does matter whether you're profitable or not.

But their profitability was 5% less than, you know, over a period of time it takes its toll.

Had they not done something about it, they would have been bankrupt.