What are your thoughts on budgeting the balance sheet for purposes of determining metrics such as GCE, Working Capital, etc.? What is your experience with the amount of effort on budgeting the balance sheet vs. P&L?
This question was asked by an attendee during the Proformative
We find that most of our clients definitely want to implement some form of budgeting for the balance sheet along with the P&L (primarily driven by the need to see estimated cash flows). I find that most companies put the most rigor into the development of the P&L and the balance sheet is a secondary exercise in the implementation to a degree. However, I would say that anyone that is implementing the balance sheet is typically paying attention to the key metrics to ensure that it all ties together and makes sense in the whole.
In particular, I find that companies will budget components of the balance sheet using certain metrics, such as the following:
1. Accounts Receivable - DSO
2. Accounts Payable - % of COGS/% of Opex/% of Non-Personnel Opex (or combination thereof)
3. Inventory - DIOH
4. Deferred Revenue - Typically Driven by Revenue Recognition Schedules and Conversion of Period Bookings to Billings
Most people budget their balance sheets at a much more summary level than the P&L (major categories such as Cash, A/R, Inventory, Fixed Assets, Depreciation, Prepaid, Other Assets, A/P, Accrued Expenses - Personnel Related and Nonpersonnel, Deferred Revenue, Notes, Other Long-Term Liabilities). In many ways, if your P&L is functioning correctly and modeled appropriately you can probably get to the balance sheet in many instances just by taking prior month balances and adjusting for associated income statement changes/metric percentages of P&L accounts.
Experience tells us that a disproportionate amount of time and effort is expended constructing a company's P&L. When the attention is turned to Balance Sheet budgeting it is performed at such a summary level that its effectiveness is called into question. To make matters worse, Cash Flow reporting, which is the natural output of the P&L and Balance Sheet, also suffers greatly.
There are many metrics / ratios that can be tracked to determine the health of a company's balance sheet. If you are interested in measuring your balance sheet performance against an internal plan or industry standards you must budget at that particular level.
The most common metrics / ratios are:
1. A/R DSO (Days Outstanding) - (Length of Time to Collect A/R)
2. A/P Turn - (Length of Time to Pay A/P)
3. Inventory Turn - (Measures How Long Items Stay In Inventory)
4. Acid Test Ratio - (Quick Assets / Current Liabilities)
5. Current Ratio - (Current Assets / Current Liabilities)
6. Working Capital - (Current Assets - Current Liabilities)
Depending on what metrics / ratios you use to manage and analyze your business you must keep all of the components in mind as you build your balance sheet budget.
