EXC 2122 Session no. 4 – 02.02.
2023
Balance sheet budgeting and financial analysis
Today's topics:
1. Why should we make balance sheet budgets?
2. Changes in assets
3. Changes in equity
4. Changes in liabilities
5. Measuring growth
6. Measuring profitability
7. Measuring liquidity
8. Measuring solidity
© Tor Olav Nordtømme, BI Norwegian Business School 2023
1. Why should we make balance sheet budgets?
A budgeted balance sheet predicts how the balance sheet looks at the end of the planning period.
There are two good reasons for making balance sheet budgets, let us first look at the first one:
• The balance sheet contains important financial information that we need to follow up, analyze and often
also need to influence.
• A Key Performance Indicator (KPI) is a parameter that we use to measure the company's performance in a
certain area that we already have found to be critical in a strategic sense ("need to have", not only "nice to
have"). We shall learn more about this in session 11!
• KPIs can be both of a financial and non-financial nature. Financial KPIs measure factors related to growth,
profitability, liquidity and solidity.
• Financial KPIs should not only focus on following up metrics that are related to the income statement. A
company's financial targets are also influenced by the development of various balance sheet items, such
as:
• The balance sheet sum (total book value of the assets)
• The Return on Investment (ROI)
• The level of inventory
• The net working capital
• The equity and rate of solidity
• Hence, when we follow up financial KPIs we do not only focus on income, costs and revenues, but also on
the balance sheet items that we can influence over time.
1. Why should we make balance sheet budgets?
The second argument for balance sheet budgeting has to do with cash flow budgeting:
• As we have already seen, we cannot make good cash flow budgets, without information about changes in
relevant balance sheet accounts.
• We need information about investments in and sales of fixed assets, loans and installments as well as
emission of new shares.
• We need information about changes in current assets and short-term liabilities to see how changes in net
working capital has an impact on cash flows.
2. Changes in assets
Fixed assets Opening balance
+ Investments (from cash flow budget)
- Depreciation (from budgeted income statement)
- Sales of assets (from budgeted income statement)
= Closing balance
Inventory Opening balance
+ Purchases (from cash flow budget)
- Consumption (from COGS in the budgeted income statement)
= Closing balance
Accounts Receivable Opening balance
+ Sales on credit (from budgeted income statement)
- Paid from customers (from cash flow budget)
= Closing balance
Sometimes it is easier to ask ourselves the question: Who owe us money
at the end of the period? If customers pay us after 30 days, the A/R per
December 31 equal the credit sales in the month of December.
Other short-term claims Opening balance
+ New claims
- Paid claims
= Closing balance
Bank deposits From cash flow budget!
3. Changes in equity
Share capital Opening balance
+ New shares at nominal value
= Closing balance
Premium fund Opening balance
+ Payments to premium fund
= Closing balance
This is relevant when the company emit new shares where the investors pay
more than the nominal value of the shares. This will normally happen when a
company is worth more than its share capital value and when existing
shareholders are not willing to let new ones in at a price that is higher than
what themselves once paid.
Retained earnings Opening balance
+ Budgeted profit after tax
- Budgeted dividend
= Closing balance
4. Changes in liabilities
Long-term loans Opening balance
+ Borrowing (from cash flow budget)
- Paid back loans (from cash flow budget)
= Closing balance
Accounts Payable Opening balance
+ Purchases on credit (from budgeted income statement)
- Payments to suppliers (from cash flow budget)
= Closing balance
It is often easier to ask the question: Who do we owe money at the end of
the period? If we pay suppliers after 30 days, the A/P per December 31
equal the purchases on credit made in the month of December.
Payable taxes Opening balance
+ New taxes this period (from budgeted income statement)
- Paid taxes (from cash flow budget)
= Closing balance
Payable VAT If all previous VAT terms are paid, the payable VAT at the end of the period
equals the output VAT less then input VAT for the last VAT term. In
Norway, where the VAT terms are bi-monthly, payable VAT December 31
will have its origin in the VAT from November and December.
5. Measuring growth
A company's historical or future growth can be determined by different factors, depending on
how we define growth:
Growth in sales income – which can be caused by volume-based growth and/or higher prices
Infrastructural growth – such as an airline company's number of destinations or the number of hotels in a
hotel chain
Product and technology growth – the ability to develop and deliver new products and services
The various growth factors are of course influencing each other; volume-based growth normally
requires infrastructural growth, and new products and services may contribute to increasing sales
volume.
Relevant for the budgeting process:
Is the company in the process of executing a growth strategy or is the goal to avoid stagnation or
a negative development? When we are making a budget, we must be able to analyze how
ambitious the strategy is in various terms of company growth, and the possible consequences this
growth may have for the sales and cost figures.
6. Measuring profitability
A traditional way to measure profitability is to compare profits with sales revenue and compute
the rate of return on sales. With NOK 50 mill in annual sales and a bottom-line profit of NOK 3
mill, the rate of return is 6 %. How profitable this is, depends on several factors, such as:
Industry average – how well are other similar companies performing?
The company's own history – how well is the company performing now, compared to previous periods?
Compared to capital employed – how well is the company performing, compared to the value of its
assets?
We must take a further look at the Return on Investments. What is the most profitable company:
Company A with NOK 50 mill in annual sales, a profit of NOK 3 mill and an average asset value of NOK 20
mill?
The competitor Company B with NOK 100 mill in annual sales, a profit of NOK 6 mill and an average asset
value of NOK 25 mill?
If we are comparing these two companies' financial performance based on rate on return of sales,
our conclusion must be that they are equally profitable. If we take a second look at the capital
turnover rate of these companies, we see that Company A has a turnover rate of 50/20 = 2.5 times
per year, while Company B has a turnover rate of 100/25 = 4.0 times per year.
The ROI of Company A is 3/20 =15 %, while the ROI of Company B is 6/25 = 24 %.
7. Measuring liquidity
A traditional way of measuring how liquid a company is, is to present the net working capital as a
ratio, where we divide the current assets value by the value of the short-term liabilities. This acid
test (or "quick ratio"), will conclude with a figure higher than 1.0 if the net working capital is
positive.
It is not a goal have to have as much current assets as possible, and two relevant questions will be:
What is the optimal net working capital?
And how can we utilize a cash surplus the best possible way? Pay back our loans? Invest in other
companies? Execute a growth strategy? Explore new markets? Develop new products and services?
The liquidity is also influenced by the three turnover rates:
1. Receivables turnover rate: Sales income/average balance on Accounts Receivable (with VAT deducted).
365/receivables turnover rate gives us actual credit period toward customers (as opposed to the formal
credit period as it is stated in the invoices to the customers)
2. Payables turnover rate: Purchases on credit/average balance on Accounts Payable (with VAT deducted).
365/payables turnover rate gives us actual credit period against suppliers.
3. Inventory turnover rate: Purchased goods/average inventory value. 365/inventory turnover rate gives us
average storage period. This can be an important tool in logistics and warehouse planning, particularly
when we analyze the turnover rate of different articles/article groups.
7. Measuring solidity
A company with a high rate of equity will be regarded as solid - it can experience a period of loss
without significant increase of its operational risk.
A company with NOK 20 mill in total assets and a total equity of 10 mill has a rate of solidity of 50
%. This will be particularly valuable for the company both if management expects a loss in 2023
or plan to expand and develop its activities.
However, how valuable this is, depends on the asset side of the balance sheet:
If the company's high equity is reflected in an equally high cash reserve, it is easier for the company to
cover any negative cash flows from its future activities
If the company's high equity instead is reflected in a large inventory or costly fixed assets, the company
may need to borrow money or sell some of its assets to be able to cover a negative cash flow from its
operational activities
Because a company can create values not only from its equity, but also from its borrowed funds,
the rate of solidity does not directly influence profitability. Many profitable companies have
relatively low rates of solidity, because they pay high dividends to their shareholders.
Hence, it is not a goal itself to have highest possible rate of solidity, but management and
shareholders must agree on what the optimal level of equity is:
• How much must be retained in the company to secure its operations and to fund future projects?
• Do the shareholders have alternative use for the surplus equity? What is the opportunity cost for them if
they let the company retain its profits?
