This article focuses on why there is a risk of too much focus on the profit and loss (P&L) or income statement and too little focus on the Balance Sheet among FP&A practitioners.

P&L figures are not a measure of success

There are 3 main financial statements:

• the Income Statement, also known as the Profit and Loss,
• the Balance Sheet (BS),
• the Cashflow (CF) statement.

The P&L records how much profit or loss has been incurred during a period by matching income and expenses associated with the economic activity of that period.

On the contrary, the Balance Sheet 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.

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.

To thrive, organizations need financial capital that 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 true that sustained profits on the P&L do not necessarily lead to healthy cashflow generation either!

Essential concept of value creation

The easiest place for the business to look to manage financial performance is the P&L. Financial performance can be managed by holding back discretionary spend, delaying capital investments or restructuring. When FP&A partners with the business, the focus naturally tends to be on the areas that lead to what I call “Management Profit” i.e. Earnings Before Interest and Tax (EBIT). Sometimes even depreciation is excluded.

By not focusing on Earnings (i.e. after tax and interest), FP&A is looking at the business from a short-term perspective. Although the ongoing tax charges and interest charges may be rather stable, Net Operating Profit After Tax (NOPAT) should be important for FP&A professionals. NOPAT is what the external world will look at when comparing companies and using return on investment and value creation frameworks.

Why is it common to focus on the P&L? It is harder for people to understand how value is embedded in the Balance Sheet since it is a static picture. By 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 tool to operationally manage value.

Using the Balance Sheet for value management

How can FP&A leverage the Balance Sheet for value management?

• Get an understanding of the balance sheet in your organization. Ideally, you need to be involved in driving 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 vs. those that support strategic growth initiatives. Track Return on Capital Invested.
• Manage the Operational Working Capital. Ensure that there is a 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 right questions are part of any strategic review and tied into the overall company strategy. For example, “can we liberate capital that is not generating a return?” or "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.

In summary

The Balance Sheet needs to be featured more prominently on the FP&A agenda. There are a couple of recommendations to keep in mind when starting the journey towards better value creation.

The article was first published in Unit 4 Prevero Blog