Maintaining Economical Balance Sheet in Financial Analysis

A typical balance sheet is an accounting tool that segregates the ‘Assets’ (what a company owns) from the ‘Liabilities and equity’ (what the company owes to others).

However, managers are often more interested in segregating the resources utilised by the operations from the resources invested in the business. This segregation helps in computing the invested capital or capital employed in a business, which is required for analysing the performance of a company. 

An economical balance sheet separates the operating items and financing items of a balance sheet.

In the upcoming video, our faculty Marie-Lys will explain how to transform a simple balance sheet into an economical balance sheet.

As you learnt in this video, the balance sheet is the closest financial statement that can be used to compute capital employed. However, both the sides of a balance sheet have mixed items, i.e., both the sides have operating and financing items. Some of the common operating and financing items in a balance sheet are given in the table below.

By segregating the operating and financing items in a balance sheet, we can transform it into an economical balance sheet. An economical balance sheet helps in computing the following measures:

Similar to a simple balance sheet, the two sides of an economical balance sheet are also always balanced. 

In the next segment, you will learn about the key metrics used for analysing the performance of a company.

----

Transcription of the Video: 

The capital employed is made out of two important items, fixed assets, essentially property, plant,
and equipment usually, and operating working capital. So, what's the right financial statement to compute the capital employed. Well, the closest statement is the balance sheet. Assets pretty close to the capital employed.

But we're not there yet. Actually on the asset side of a balance sheet, some operating and
financing items are a bit mixed up and it's the same thing on the liabilities and equity side.
So, let's have a look together. Property, plant, and equipment. Is that an operating item or a
financing item? I think we all agree, it's an operating item.

Inventories, accounts receivable, are they operating or financing items? Operating, definitely.
Then we have cash. Is cash an operating or a financing item? Here, we're a bit in a grey zone.
Some of us will say, yes, cash is an operating item because we do need to keep a bit of a cash
buffer to secure our operations.

Others will say, no, cash is a financing item. It's in the hand of the financing people and it depends
very much on how much that they have borrowed from banks. So, that's why I was saying we are in a grey zone. Cash is partly operating and partly financing. For the sake of simplification, usually we consider that cash is a financing item, more than an operating item. So, let's consider cash a financing item.

How about the other side of the balance sheet? Owner's equity, oh, that's clearly a financing item.
We said the company's fund holders, the financing parties or the shareholders and the bankers.
So, owner's equity, long-term debt, short-term debt or all financing items.

And how about accounts payable? Well, accounts payable, this is the money that we owe to our
suppliers. So, it depends on the negotiations run by the procurement people.
Procurement is completely part of operations. So, accounts payable are definitely an operating item.

And you see that's exactly what we were fearing from, our balance sheet is a bit mixing up on both
sides, operating and financing item. So, let's do some clean up together. I suggest the following. First, let's subtract cash on both sides of the balance sheet. In that way, the cash will disappear from the left-hand side. Good use, we get treats of a financing item that was isolated amongst several operating items.

And on the right-hand side, what do we see appearing? Well, we see long-term debt plus
short-term debt, minus cash. It is all managed by people who look at how much money shall we borrow from banks or reimburse to banks. And that's what we call the net debt. It's the entire debt, net of the cash the
company holds.

What's next? Now I would like to subtract accounts payable on both sides of my balance sheet
again, so that they disappear from the right hand side and we're now left with financing items only. And on the left-hand side, we'll see appearing inventory, plus accounts receivable, minus accounts
payable, that's our operating working capital.

And there we are, on the left hand side, we are left with only operating items, namely property,
plant and equipment. Plus the working capital. That's what we previously called the capital employed. And on the right-hand side, we're left with
owner's equity and net debt. This is the so-called invested capital.

And we are reaching now what we call the economical balance sheet. We've transformed a bit the
accounting tool into more of a managerial tool. A tool that separates better the operations from the financing activities. And that's very important because that's how things happen on a day-to-day basis in the company. Operations are managed on one hand and financing activities on another hand. See my
economical balance sheet is still balanced and that's important.