25
The Magic of Managing the Balance Sheet
We’ve mentioned the phrase managing the balance sheet a couple of times in this book. Right now, we want to go into greater detail about how to do it. The reason? Astute management of the balance sheet is like financial magic. It allows you to improve your company’s financial performance even without boosting sales or lowering costs. Better balance sheet management makes a business more efficient at converting inputs to outputs and ultimately to cash. It speeds up the cash conversion cycle, a concept that we’ll take up later in this part. Companies that can generate more cash in less time have greater freedom of action; they aren’t so dependent on outside investors or lenders.
If your company is big enough to have a CFO and a finance department, they will have day-to-day responsibility for managing most of the balance sheet. They’ll help you figure out how much to borrow and on what terms, help you line up equity investment when necessary, and generally keep an eye on the company’s overall assets and liabilities. But any business owner, with or (especially) without a finance department, should understand the key concepts involved in managing the balance sheet. In particular, you need to understand the idea of managing working capital. Learn to help your people manage working capital better, and you will have a powerful effect on both your company’s profitability and its cash position.
THE ELEMENTS OF WORKING CAPITAL
Working capital is a category of resources that includes cash, inventory, and receivables, minus whatever a company owes in the short term. It comes straight from the balance sheet, and it’s often calculated according to the following formula:
working capital = current assets – current liabilities
Of course, this equation can be broken down further. Current assets, as we have seen, includes items such as cash, receivables, and inventory. Current liabilities includes payables and other short-term obligations. But these aren’t isolated line items on the balance sheet; they represent different stages of the production cycle and different forms of working capital.
To understand this, imagine a small manufacturing company. Every production cycle begins with cash, which is the first component of working capital. The company takes the cash and buys some raw materials. That creates raw-materials inventory, a second component of working capital. Then the raw materials are used in production, creating work-in-process inventory and eventually finished-goods inventory, also part of the “inventory” component of working capital. Finally, the company sells the goods to customers, creating receivables, which are the third and last component of working capital (figure 25-1). In a service business, the cycle is similar but simpler. For example, our own company—the Business Literacy Institute—is partly a training business. Its operating cycle involves the time required to go from the initial development of training materials, to the completion of training classes, and finally to the collection of the bill. The more efficient we are in finishing a project and following up on collections, the healthier our profitability and cash flow will be. In fact, the best way to make money in a service business is to provide the service quickly and well and then to collect as soon as possible. Throughout this cycle, the form taken by working capital changes. But the amount doesn’t change unless more cash enters the system—for example, from loans or from equity investments.
Of course, if the company buys on credit, then some of the cash remains intact—but a corresponding “payables” line is created on the liabilities side of the balance sheet. So that must be deducted from the three other components to get an accurate picture of the company’s working capital.
Overall, how much working capital is appropriate for a company? This question doesn’t have an easy answer. Every company needs enough cash and inventory to do its job. The larger it is and the faster it is growing, the more working capital it is likely to need. But the real challenge is to use working capital efficiently. The three working capital accounts that you and your employees can affect day in and day out are accounts receivable, inventory, and (to a lesser extent) accounts payable. We’ll take up each one in turn.
Before we do, though, it’s worth asking once again how much art is involved in all these calculations. In this case the best answer might be “some.” Cash is a hard number, not easily subject to manipulation. Receivables and payables are relatively hard as well. Inventory isn’t quite so hard. Various accounting techniques and assumptions allow a company to value inventory in different ways. So a company’s calculation of working capital will depend to an extent on the rules its accountant follows. Still, you can generally assume that working capital figures aren’t subject to as much discretion and judgment as many of the numbers we learned about earlier.