Balanced Approach to Financial Management

I remember a partner in a small CPA firm telling a story from early in his career. He said he had been given the task of creating a balance sheet for a client. When it was in balance he declared, “It balances, so it must be correct.” Of course the balance sheet must balance, but he quickly learned there was a lot more to it than that.

Balance Does Matter

One of the first areas where a company often displays a lack of balance is on the importance of the different financial statements. The income statement shows the results of activities over a specific period of time, while the balance sheet is often referred to as a snapshot of where a company is financially at a particular point in time. Unfortunately management frequently has an unbalanced approach to how they view the importance of each of these. Most often they become almost completely focused on profitability, which means they see the income statement as the most important. This is a mistake. I suggest that we make neither more important than the other.

Why?

I have seen a number of companies that on paper were reasonably profitable according to the income statement. On the other hand, the weakness of the balance sheet represented a threat to the company. For example, in the posting Cash Flow–The Bottom Line we looked at the importance of profit eventually being converted to cash. If this does not happen a company will eventually fail. The bills have to be paid and that cannot happen without adequate cash.

When I say “profitable on paper” I mean that if the company fails as a result of insufficient cash then the profits essentially go away. The likelihood of collecting outstanding receivables or selling inventory for full value is dramatically reduced. As a result the profit the company thought it had quickly evaporates.

Balanced Approach

My suggestion is that companies be deliberate about managing both the balance sheet and the income statement. On the balance sheet that means doing such things as collecting accounts receivable in a timely manner and making sure that inventory turnover is appropriate. In addition, be aware of the importance of avoiding debt if possible, and if necessary that it is used correctly. Remember, short-term debt should be used for short-term obligations and paid off in a timely manner, For example, if accounts payable is allowed to become too  past due it begins to be more like long-term debt being used to finance a current asset that may have been used far earlier than the accounts payable is paid. On the other hand, reserve long-term debt for purchases that will have a long life such as furniture and production equipment.

On the income statement it is importance to examine trends. Are operating expenses increasing disproportionately? Is gross profit percentage being reduced because supplier pricing is too high or the prices for goods and services sold are too low?

Of course, these are just a few things to consider, but the point is to not put all your emphasis on managing one statement over the other. The income statement and the balance sheet impact one another and it is essential to actively manage both if your company is to be successful long-term.

What is your approach? Are you putting too much emphasis on the income statement at the expense of the balance sheet or vice versa? If you are unsure of how to get an appropriate balance to financial management then perhaps a Part-time CFO or Controller is in order. AimCFO would love to help you.

If you want to know more, contact AimCFO – Contact

As always, your comments are welcomed.

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