Financial Trinity: Balance Sheet then the P&L and Cashflow

I am starting to play chess again and I am finding it a rather scary experience because everything is totally exposed, except of course what is going through the minds of the two players.

In my early days of learning to play, I was often defeated by opponents who took advantage of my focus on offensive strategy and my non-defence of whatever they were up to, until it was too late, frustratingly all in plain sight. Eventually I gave my true chess nemesis, my Dad, a three-dimensional chess board which defeated him, after years of my own recurring failure. He hadn’t trained himself to consider the third dimension. The Financial Trinity

Some of the best and worst things in life come in threes. One of the most pivotal Trinities in business finance is that which exists between the Profit & Loss Account (P&L), Balance Sheet and Cashflow, the three main elements of every business’ Financial Statements.

Rather like my Dad, business managers often become competent at managing their P&L in conjunction with their business’ Cashflow. Yet somehow the Balance Sheet sits in a technical blindspot that is all too easily ignored. When the time comes for someone like an auditor to conduct a proper review, it is often too late to do anything to rectify the inevitable errors that such lack of oversight has allowed to creep in.

In a different post, I talked of the Profit & Loss Account’s EBITDA, a common point of reference for investors, managers and shareholders to manage performance. The EBITDA article also looked at how things can be manipulated for personal gain (read here).

Cashflow is another vital topic, which richly deserves a whole series of articles to explain how it works and how vital it is to the day-to-day running of a business.

Today I am going to talk about the Holy Ghost of Financial Statements, the Balance Sheet. In fact I should call it the Father, as it begets the other two.

Balance Sheet v. Profit & Loss Account

Whenever I meet a finance team for the first time I ask them whether they are more focussed on the Balance Sheet or the Profit & Loss Account. All too often I am afraid that the answer tends to be the Profit & Loss Account.

Personally as a CFO, the Balance Sheet is my priority because it is a historical statement of assets and liabilities of a business at designated points in time. The P&L and Cashflows are the opposite, measuring only the movements between these Balance Sheet points. To my mind, if two points are correctly fixed, then the movements between them look after themselves. Critically the same cannot be said in reverse!

Navigating a Balance Sheet can be a mixture of the known and the unknown. At a particular moment, each asset can usually be verified; its existence, historical cost, ownership are all provable to a greater or lesser extent.

Liabilities are trickier as they hide in the shadows more and have a nasty habit of emerging when they are least expected, or wanted. Rather like the obnoxious uncle at a family gathering, an unexpected liability can totally ruin the party because, thanks to the wonders of double-entry bookkeeping, the forgotten liability often has a devastating impact on the vital performance metrics of the Profit & Loss Account, its discovery leaving little or no time for managers to make necessary changes.

So what to do? Like all blindspots, you only need to focus on the subject matter and the blindness tends to go away.

Review the Balance Sheet It is good practice for financial staff to prepare detailed schedules and reconciliations supporting all balance sheet items at least every month, in the same way as one would in preparation for the external annual audit. In fact I believe that it is helpful if the Prime Ledgers (Cashbook, Purchase Ledger and Sales Ledger) are reconciled every week, lightening the month-end workload of course but also ensuring that the human errors are picked up in good time.

These prepared schedules need to be reviewed and approved by the most senior financial executive in the business, if not then by the CEO. Otherwise situations can develop over time so that, when/if a balance sheet is eventually critically reviewed, one often finds that major adjustments and write-offs are needed. And Murphy’s Law indicates that such adjustments seldom have a positive P&L impact!

Manage the Risk - Understand the Trinity

It is risky for financial and management focus to be only on profitability and cash flow. Income statements, cash flow statements and balance sheets are all closely inter-linked. An issue in one of them has a direct impact on one of the others.

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