The Balance Sheet and FP&A
Posted by Amrish Shah
What is this article about?
This article focuses on why there is a risk of too much focus on the P&L (or income statement) and too little focus on the Balance Sheet amongst FP&A practitioners.
Why is it important?
There are 3 main financial statements – the Income Statement, also known as the Profit and Loss, the Balance Sheet and the Cashflow statement. The P&L records how much profit or loss has been incurred for the period by matching income and expenses associated with the economic activity of that period. The Balance Sheet in contrast is a snapshot at the end of the accounting period that gives a view on how the organization is funded and how those funds are split between assets and liabilities that will impact the P&L in the coming periods. And finally, the CF statement is a flow – showing how the cash position of the organization has changed in the period, due to the economic activity recorded on both the P&L and the changes in balances recorded in the BS.
In order for any organisation to not just survive but thrive, it needs financial capital, and this then needs to be allocated in a way where the strengths of the assets are sustainably stronger than the liabilities. Ultimately, over the long term, this is seen through the generation of positive cashflows. Whilst it is hard to imagine that sustained losses on the P&L would ever lead to positive cashflows, it is also conceivable that sustained profits on the P&L do not necessarily lead to healthy cashflow generation either!
Why the Income Statement and not the Balance Sheet?
Especially in times of stress, the easiest place for the business to look to “manage financial performance” is the P&L. By holding back on discretionary spend. Or delaying capital investments. Or restructuring. As FP&A partners the business the focus then naturally tends to be on the areas that lead to what I call “Management Profit” so Earnings Before Interest and Tax (EBIT). Sometimes even depreciation is excluded.
The fact that FP&A does not focus on Earnings (i.e. after tax and interest) is too short term focused in my view. Yes, it is likely that ongoing tax charges and interest charges may be rather stable and even “notional” in nature, but from a mindset perspective what should matter to FP&A is the Net Operating Profit After Tax (NOPAT). NOPAT is what the external world will look to when analysing between companies and is what is used in all return on investment and value creation frameworks.
Why such a focus on the P&L? Simply because it is harder for people, including sometimes regrettably FP&A, to understand how value is embedded in the Balance Sheet as opposed to something they can more viscerally feel in the P&L. Concepts such as off balance sheet financing, contingent liabilities etc have long been seen as in the domain of fundamental technical financial accounting. Not a place for FP&A to meddle in.
In forgetting that the essential concept of value creation is the deployment of financial capital to create stronger assets and to fund them (through liabilities, equity or debt) as efficiently as possible, FP&A ignores the balance sheet as a key level to operationally manage value.
How can this be addressed? In my view there are a few simple things that FP&A can start with. These are:
- Get an understanding of the balance sheet in the first instance in your organization. Ideally by being involved or having the responsibility to drive balance sheet reconciliations and balance sheet reviews.
- Bring capital investment performance metrics into the ongoing performance dialogue. Track simple metrics such as capex % depreciation. Help define capital projects into those that are maintenance versus those that support strategic growth initiatives. Track Return on Capital Invested.
- Do the same for Operational Working Capital. Ensure there is clear responsibility for FP&A to support the Operations to manage Inventory more effectively and efficiently, balancing the trade-offs between customer service, quality and cost. Partner with the Accounts Receivables and Accounts Payable teams to ensure the right performance metrics are being made visible.
- Bring the same level of process leadership and robustness to balance sheet and capital spending planning, forecasting and budgeting. If appropriate, apply zero based budgeting to capital.
- Ensure the question “can we liberate capital that is not generating a return” is always part of any strategic review and tied into the overall company strategy. How can the liability profile (incl. funding) better match the assets that the organization wants to focus on winning with?
- Partner with the business to work on strengthening governance around capital investment and balance sheet risk management. This to avoid putting at risk the right behaviours and mindset being put in place to manage organization value in a more holistic way.
A final word
I hope in this article I have shown why the Balance Sheet needs to feature more prominently on the FP&A agenda and how that can happen with a few easy starting points.