How Much Attention Should Managers Pay to Balance Sheet Essay

Introduction

The main objective of a commercial organization is to maximize the wealth of the shareholders. The role of every manager within an organization is therefore, directed towards this goal.[1]

Since every function is linked to financial parameters, it is logical that every manager should be interested in the financial statements of the company. One of the two major financial statements that every organization generates is the Balance Sheet. The Balance Sheet provides a snap shot view of the organization as at a particular point in time, and gives valuable information regarding the health of the organization. Such information includes the assets owned, the payments and other dues owed, and the amount of funds brought in by the company’s owners. Details of these items show to different managers the efficiency with which their function is being performed.

This paper examines the question of how much attention managers should pay on a day-to-day basis to the balance sheet of the company. Since the balance sheet is prepared periodically, and usually published once in a year, strictly speaking it does not have a day-to-day significance. However, provisional balance sheets can be prepared periodically, and more importantly, even the annual balance sheet figures can serve as an appropriate guideline in the day-to-day management of the company’s affairs. The rest of this paper is devoted to a discussion on how this could be of help to various functions and different aspects of the business.

Functions of Management
“Management is creative problem solving. This creative problem solving is accomplished through four functions of management: planning, organizing, leading and controlling. The intended result is the use of an organization’s resources in a way that accomplishes its mission and objectives.”[2] To carry out these tasks, managers will need to take various decisions. “In decision making, managers strive to allocate resources in the most productive way, to encourage innovation and change, and to negotiate with other managers and groups within the organization in order to develop it further.”[3] As discussed earlier, the key financial objective of the organization is to enhance the wealth of the owners. Accounting information helps managers in this process by enabling them to

Develop Strategic Plans
Evaluating and controlling performance
Allocating resources
Determining costs and benefits[4]
How Financial Statements can help managers
Financial Statements can help managers to effect various types of controls in their operations. These include:

Credit Control
Staff Control
Stock Control
Profitability Control[5]
The three important financial statements published by companies are: Profit and Loss Account, Balance Sheet, and Cash Flow Statement.[6]

The balance sheet is a rich source of information regarding the performance of a company. “The balance sheet can provide useful insights into the financing and investing activities of a business.”[7] The balance sheet enables an individual to examine the following aspects of the financial position:

§  Liquidity of the business

§  Mix of Assets

§  Financial structuring[8]

“The managerial approach to accounts and financial aspects is concerned with the use, evaluation, interpretation, analysis and judgement of the financial data and what it means for the present and future of the organization.”  Financial data provide the basis for decision-making.[9] Decisions may concern operational matters or matters requiring a longer-term perspective concerning investment decisions. In both cases balance sheet figures can help managers. Investment decisions and planning are made using several approaches that include Capital Budgeting, Accounting Rate of Return, Payback period, and Discounted Cash Flow methods.[10]  Each of these methods will in turn require data that can justify assumptions and provide a basis for these calculations. For example, Accounting Rate of Return and payback period will require data about the investments made in the business and the Asset base on which the business is operating. Investment decisions will also involve the question of funding. The methods stated above, such as rate of return will give the manager an idea of whether a particular investment is worth considering. Once it is decided that a particular investment is worthwhile, the manager would need to find means of procuring and making available the funds that would need to be invested. This would require decisions to be made regarding the source of funds such as Debt, Equity and other types of funds, and whether they should be long-term or short-term. All these decisions require information from the balance sheet regarding the capital structure such as the ratio of debt-to-equity or the gearing.

“The financial position of an enterprise is affected by the economic resources it controls, its liquidity and solvency”[11] Information about the financial resources available to a company, and the way it has been employed, can be important in predicting future cash flows and the likely application of such cash flows. It would also provide an insight into the likely trend of future performance and the capacity of the organization to raise funds.

An organization’s operating activities depend on various factors such as the nature of the business, the organization’s plans and “input markets”, which include raw materials, labour, technology markets and consumer markets. “”Management decides on the most efficient and effective mix (of these) for their company’s competitive advantage.”[12]

Thus financial statements are of vital importance to every aspect of a business and require close attention from every manager. It enables managers to make various vital and crucial decisions. Financial statements provide general data that can be analysed using specialised tools and techniques to provide useful estimates and inferences that can support vital business decisions. Financial statement analysis provides the manager with the tools that enable decision-making. “It is a screening tool in selecting investment or merger candidates, and is a forecasting tool of future financial conditions and consequences. It is a diagnostic tool in assessing financing, investing and operating activities, and is an evaluation tool for managerial and other business decisions.”[13]

The wide-ranging nature of the financial statements and the universality of their applications become amply clear from the above. As one of the two most important financial statements produced by an organization, the importance of the balance sheet and its contents to every manager becomes evident. The next question is: what are the main contents of the balance sheet, how they are analysed, and how their analysis helps in each aspect of the business.

Financial Statement Analysis
Analysis of the balance sheet and other financial statements is directed towards one of the following areas:

Short Term Liquidity
Funds Flow/ Future Availability and disposition of cash
Capital Structure and Long-term solvency
Return on Investment
Asset Utilization
Operating Performance.[14]
Ratio analysis is one of the most common methods of analysing financial statements. Although there are a number of standard ratios that are usually analysed, “managers and analysts can and do invent their own ratios as they see the need.”[15]

“The cash flow statement provides additional information on interest cover, working capital and fixed asset investments and financing cash flows.”[16] The statement of Changes in Owners’ Equity shows how the income of the company has been distributed and how owners’ wealth has changed.

Balance Sheet Items

The balance sheet “is a statement of the manner in which the firm holds its wealth, how much of its wealth it has in each category, how much of the wealth that the firm controls is committed to outsiders and the net wealth of the firm”[17]

The contents of the balance sheet include:

§  Fixed Assets – Intangible Assets, Tangible Assets, Leased Assets, Investments

§  Current Assets – Stock, Debtors, cash

§  Creditors

§  Provisions

§  Capital and Reserves[18]

In turn these will give information about liquidity, solvency, returns, efficiency and utilization. Various types of analyses can measure these. For example, activity ratios can be used to assess how efficiently the short-term assets and liabilities are being managed.[19]  The balance sheet can give information about long-term and short-term creditors, shareholders’ funds, value per share, fixed assets, net cash position, and net gearing.[20] This can be further broken down into the following eight items for a more detailed analysis and understanding of a company’s business.

§  Fixed Assets

§  Cash and Cash Equivalents

§  Inventory

§  Debtors

§  Trade Creditors

§  Long term Loans

§  Shareholders’ Equity

§  Investments

Fixed Assets

Some of the important information that will be available from the Assets side of the balance sheet includes how assets are structured, how they are employed, and what return they provide.

There are several ratios that can give the manager an idea of how efficiently the assets of the organization are being employed. These ratios are helpful in comparing the performance of the organization with those of similar companies in the industry so that an idea can be gained about where the organization stands, and what its strengths and weaknesses are. The ratios that of relevance in this respect include:

Return on Assets: This shows how much net income the company is generating for each unit of fixed assets.

Asset-Turnover Ratio: This shows how efficiently the assets are used, by revealing the sales turnover obtained for each unit of asset. The higher the turnover to asset ratio, the better the performance. Performance levels can be affected by manufacturing inefficiency, failure to sell to full capacity, or lack of various other input resources such as material.

The net assets can provide a rough guide to the net worth of the business.[21]

Current Assets

These include cash and cash equivalents, Inventory and Debtors. As far as the operating personnel are concerned, perhaps the most relevant and significant information can be provided by current assets and working capital. Current Assets can show how efficiently the operations are being managed. The current assets-to-turnover ratio as a subset of the assets-turnover ratio can indicate how much current assets are being used. Again the composition of the current assets will provide important clues about where the company is using higher amounts of current assets. This can be understood from specific ratios such as the inventory-turnover ratio.

Another important indicator of the efficiency of operations includes information of how fast the current assets are “turning over”. Holding higher levels of inventories or carrying higher levels of debtors represents additional cost to the company. The average number of days of inventory held at any time can be a useful measure to know how much inventory is held. In a trading organization, this can be directly computed as the number of times the inventory turns over by dividing the total sales for the year by the inventory level. In manufacturing organizations that convert the raw material into finished goods, this may need a percentage to be applied on the turnover of finished goods. Alternately, it could be computed as the ratio of the inventory to total relevant purchases or consumption during the year.

As far as debtors are concerned, the number of days it takes on average to realize a debt is a good measure to be employed.[22] This can be computed as the total credit sales during the year divided by the figure of debtors in the balance sheet. A more accurate figure can be arrived at by taking the average of the opening and closing inventories. Preparation of provisional balance sheets for internal use can make the process more accurate and timely.

Current Assets can be compared to Current Liabilities to provide an idea of the liquidity position of the organization.

Liabilities

Liabilities on the balance sheet show how vulnerable the organization is. Liabilities are divided into short-term and long-term liabilities.

Short Term Liabilities/ Trade Creditors

The short-term debts represent a company’s obligations in the short-term. This will affect the short-term liquidity of the company. A company can be considered to be safe in the short-term, and capable of meeting its short-term liabilities if it has enough quick or short-term assets. “Firms that are unable to roll forward their short-term borrowings may have to sell assets to meet their liabilities, one of the symptoms of financial distress. Extensive use of trade credit also carries similar risks of non-renewal”[23]

Thus the ratio of short-term assets to short-term liabilities indicates how comfortable an organization is for meeting its short-term commitments. Banks generally take a favourable view of firms maintaining a current asset-to-current liabilities ratio of 2:1[24]

As in the case of assets, it is possible to measure how efficiently the company is managing its liabilities also. It is more advantageous to obtain terms of credit such that the organization gets the maximum period to pay its short-term dues. A measure of this can be obtained from the average creditors’ payment period, which can be calculated as the ratio of (creditors/purchases for the period) x 365. [25]

Long Term Debts and Solvency

The other important measure is the company’s ability to meet its long-term commitments. A manager can get an idea of the company’s position in this respect by looking at the long-term debts, total assets employed, and the interest burden. There are three ratios that are of relevance:

§  Long-term debt to net assets

§  Total debt to total assets

§  Interest cover[26]

Shareholders’ Equity

This shows how much the company is worth and what the owners of the company possess. Since the objective of a commercial organization is to maximize the owners’ wealth, this figure assumes great importance. Changes in this figure, the pattern of distribution of the income, and the value and earnings generated per share are of interest to the manager. The return on Equity is also an important consideration that is closely related to the above. Although there is no explicit cost of equity capital like in the case of debt, “there is an implicit rate of return that has to be offered to attract investors.”[27]

Investments

Investments represent the company’s spare funds that have not been invested in the company’s business, and therefore a kind of reserve fund that can be tapped. It also represents the efficiency with which the company is able to utilize its spare funds.

Gearing

Apart from these ratios that show how the borrowings are related to the assets employed, a company is also interested in examining the structure of its liabilities. The capital structure of the company is determined by the proportion of Share capital and Reserves to long-term borrowings. Gearing is the relationship between loan capital and share capital.[28]

A company’s source of funds includes the share capital, and one of the items on the liabilities side of the balance sheet is Shareholders’ equity. A company is generally considered to be safe if the shareholders’ equity is sufficiently large. At one extreme, the safest situation would be one in which the firm has no debts at all, for in this case, there is no obligation to repay any amount. On the other hand a good mix of debt funds along with equity ensures better returns on equity capital in good times, because the interest on borrowed funds is fixed irrespective of the profits earned. When the going is good, this leaves more in hands of the shareholders after the interest burden has been met. Thus it is advantageous to have a judicious mix of debt and equity, such that there is a balance between risk and return. For this reason, the structure of the liabilities side of the balance sheet becomes important. This is represented by the gearing or leverage employed by the company, and is measured by the total of debts to total of equity funds, both figures being available from the balance sheet.

Conclusion

Analysis of the balance sheet on a regular basis should be an essential part of every manager’s function. Such analysis can give important insights into the efficiency and effectiveness of every manager’s operations. Many decisions need to be taken in the light of the information that is available from the balance sheet of the company. These include operating decisions, investment decisions, and financing decisions. Thus managers need to pay a lot of attention to the balance sheet of the company on a day-to-day basis as well as on long-term basis.
Works Cited

Arnold, Glen. Corporate financial Management: 2nd Edition. Essex, Pearson Education Limited, 2002
Atrill, Peter and McLaney, Eddie. Management Accounting for Decision Makers: Fourth Edition. Essex, Pearson Education Ltd, 2005.
Atrill, Peter ; McLaney, Eddie. Accounting and Finance for non-specialists: Third Edition. Essex: Pearson Education Ltd., 2001.
Bendrey, Mike, Hussey, Roger ; West, Colston.  Essentials of Financial Accounting in Business. London, Thomson Learning, 2004.
Bernstein, Leopold A ; Wild, John J. Analysis of Financial Statements: Fifth Edition. New Delhi, Tata-McGraw-Hill Publishing Company Ltd., 2004.
Brett, Michael.  How to Figure Out Company Accounts. London, Texere LLC, 2003
Elliott, Barry and Elliott, Jamie. Financial Accounting and Reporting: Seventh Edition. Essex, Pearson Education Ltd., 2003.
Erven, Bernard L. ManagementExcel: Functions of Management. February 24, 1999, Retrieved 30 March 2007 ;http://www2.ag.ohio-state.edu/~mgtexcel/Function.html;.
Glynn, John, Perrin, John and Murphy, Michael. Accounting for Managers: Second Edition. London, International Thomson Business Press, 1998.
Hennagan, Tim. Management Concepts and Practices: Fourth Edition. Essex, Pearson Education Ltd., 2005.
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Knott, Geoffrey. Financial Management: Fourth Edition. New York, Palgrave Macmillan, 2004.
McLaney, Eddie. Business Finance: Theory and Practice: Fifth Edition. Essex, Pearson Education Limited, 2000
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Pendlebury, Maurice ; Groves, Roger. Company Accounts: Analysis, Interpretation and Understanding: Fourth Edition .  London, International Thomson Business Press, 1999
Pettinger, Richard. Introduction to Management: Third Edition. New York, Palgrave, 2002.
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[1] B. Neale, Bill and T. McElroy. Business Finance: A Value-Based Approach. Essex, England: Pearson Education Limited, 2004, pp.10-11.
[2] B.L. Erven,. ManagementExcel: Functions of Management. February 24, 1999, Retrieved 30 March 2007, ;http://www2.ag.ohio-state.edu/~mgtexcel/Function.html;.
[3] T. Hennagan. Management Concepts and Practices: Fourth Edition. Essex, Pearson Education Ltd., 2005, p.18.
[4] P.Atrill ; E. McLaney. Management Accounting for Decision Makers: Fourth Edition. Essex, Pearson Education Ltd, 2005, pp.16-18.
[5] G. Whitehead. Bookkeeping and Accounting:  Fourth Edition. London, Financial Times Management, 1998, pp.246-256.
[6] M. Bendrey, R. Hussey ; C. West.  Essentials of Financial Accounting in Business. London, Thomson Learning, 2004, p.308.
[7] P.Atrill  ; E. McLaney. Accounting and Finance for non-specialists: Third Edition. Essex: Pearson Education Ltd., 2001, p.41.
[8] Atrill ; McLaney, 2001, p.41
[9] R. Pettinger. Introduction to Management: Third Edition. New York, Palgrave, 2002, p. 219
[10] J. Glynn, J. Perrin ; M. Murphy. Accounting for Managers: Second Edition. London, International Thomson Business Press, 1998, pp.287-290
[11] B. Rees. Financial Analysis: Second Edition. Hertfordsshire (UK), Prentice Hall International (UK) Ltd., 1995, p.57.
[12] L. Bernstein ; J. Wild. Analysis of Financial Statements: Fifth Edition. New Delhi, Tata-McGraw-Hill Publishing Company Ltd., 2004, p.15.
[13] Bernstein ; Wild, p.4
[14] Bernstein ; Wild, p.31
[15] A. Warman, ; J. Davies. Accounting: A Systems Approach. London, International Business Thomson Press, 1999, p. 269.
[16] B. Elliott ; J. Elliott. Financial Accounting and Reporting: Seventh Edition. Essex, Pearson Education Ltd., 2003, p.656
[17] E. McLaney. Business Finance: Theory and Practice. Essex, Pearson Education Limited, 2000, p.37
[18]  M.Pendlebury ; R.Groves. Company Accounts: Analysis, Interpretation and Understanding: Fourth Edition .London, International Thomson Business Press, 1999, pp. 54- 62
[19] D. Watson and T. Head. Corporate Finance: Principles and Practice. London, Financial Times Management, 1998, p.37.
[20] M. Brett.  How to Figure Out Company Accounts. London, Texere LLC, 2003, p. 138
[21] R. Jones. Business Accounting. Lancashire, Causeway Press Ltd., 2002, p.411.
[22] G.  Knott. Financial Management: Fourth Edition. New York, Palgrave Macmillon, 2004, p.24
[23] Neale ; McElroy, p.219.
[24]G.  Knott, pp.21-23
[25] G. Knott, p.25.
[26] G. Knott, pp.26-27
[27] G. Arnold. Corporate financial Management: 2nd Edition. Essex, Pearson Education Limited, 2002, p.727.
[28] R. Jones, p.412.