Corporations are managed predominantly on the basis of the income statement. This claim is supported by the fact that target setting for budgets and forecasts is generally done on operating profit (or EBIT or EBITDA, if you like). It is in addition common practice to internally present the balance sheet according external reporting standards such as IFRS. This is not the most intuitive reporting layout; especially not for non-financial colleagues.
This is a pity, as the balance sheet sits in the middle between accounting profits and their conversion into physical cash flows. This concept alone should provide enough substance to have the balance sheet in a more dominant position in a corporation’s planning & control cycle. There are some relatively simple measures to achieve this.
The income statement and cash flow statement are divided into three categories: operating activities, investing activities, and financing activities. Within the income statement, the revenues, cost of goods sold, and operating expenses together represent the operating activities. Depreciation and amortization are the consequence of investing activities; financial income and expenses of financing activities.
When looking at the balance sheet from this perspective, the operating working capital and provisions mirror the corporation’s operating activities. Property, plant and equipment and intangible assets illustrate the level of investing activities. Equity and interest-bearing loans and borrowings represent the financing activities. This way of balance sheet presentation is commonly known as the Capital Employed model, where the total of operating activities and investing activities equals the capital employed. An interesting unit of measure when calculating the return on investment.
Working capital in turn can be made much more transparent by moving away from the traditional breakdown into current assets and current liabilities. Classify the positions by nature: amounts received and paid in advance, amounts invoiced, and accrued amounts. Group these positions by counterparty: customers, suppliers, employees, and tax authorities. The end result is a working capital report that is also understandable by the rest of the Management Board.
A next step in better managing the balance sheet is achieved by separating balance sheet items that are managed by the operations from items managed by the corporate center. In general, the corporate center’s Group Treasury department manages equity and interest-bearing loans and borrowings; Group M&A manages business combinations; and the Group Tax department manages the tax structure. Therefore, keep these balance sheet items clearly separated from the items the operations are supposed to be held accountable for. As a consequence there are two types of capital employed: operating capital employed and corporate capital employed. Operating capital employed is to be budgeted bottom-up, while corporate capital employed is to be budgeted top-down.
Applying these measures require the finance departments to think less as accountants, and more as asset managers. It also requires more collaboration between the corporate center and the operations. This may prove to feel a bit uneasy at first, but experience shows that in the end it will result in much more understanding of and grip on the balance sheet. This in turn will produce more accurate and relevant budgets and forecasts, enabling the Management Board to be more effective with balance sheet management.