Daptiv, Inc., a Seattle-based provider of on-demand collaboration software for businesses, sells annual software contracts to its clients. Given the way in which it receives cash and records revenue — Daptiv gets paid at the beginning of the contracts and then recognizes revenue over the next 12 months — the income statement, despite the attention it generally receives during the budgeting process, has numbers that don't always provide a clear picture of the company's financial health and future, notes Nancy Ordway, chief financial officer.
During Daptiv's budget process, Ordway pays close attention to several numbers and ratios that don't appear on the income statement. One is the deferred revenue account on the balance sheet, which shows the revenue that Daptiv will be recognizing over the upcoming 12 months. A downward trend here most likely indicates stagnating business. “In our case, the income statement can look pretty good, but the balance sheet can show that we're not doing as well as you would believe,” Ordway says. Daptiv uses Budget Maestro from Centage Corporation.
Another balance sheet item that gets a lot of attention is the cash account. Even though Daptiv receives payment at the start of each contract, the company is growing quickly — in 2007, the total number of users jumped by 116 percent, to more than 700 — and this growth consumes cash. Management ties some activities, such as the hiring of new employees, to its projected cash levels. “If we just looked at the income statement, we wouldn't know our cash position,” notes Ordway.
Until recently, many financial departments would prepare budgeted income statements each year and then simply let balance sheet and cash flow follow from those, says Steve Player, North American program director for the Beyond Budgeting Round Table, a not-for-profit collaborative dedicated to helping organizations improve their performance management. In addition, Player, who writes a regular column for Business Finance, is chief executive officer with The Player Group, a Dallas-based consulting firm.
Focusing on numbers from just one statement can prompt some “less than stellar” business decisions, adds Alan Anderson, CPA and managing principal of accounting and assurance services with LarsonAllen LLP, Minneapolis. For instance, management may set a goal of ramping up sales by 20 percent but neglect to factor in the impact of higher receivables on working capital.
Now, a growing number of financial executives are taking a more holistic approach to budgeting and placing greater emphasis on budgeting for the cash flow statement and balance sheet, as well as the income statement. Just four or five years ago, about 50 percent of clients prepared budget balance sheets, says John Orlando, chief financial officer with Centage Corporation in Natick, Mass., a provider of budgeting software. Now, about 90 percent do, he estimates.
In fact, business unit leaders at some companies today are taking responsibility for cash flow and balance sheet numbers, as well as measures tied to the income statement, says Chris Houle at Quantrix, a provider of business analytic software in Portland, Me. “The three primary statements have to be tightly integrated in a robust business model.”
Perhaps the greatest driver behind this trend is the need to more precisely forecast cash flows. This is particularly true for companies that are self-funded and have less of a margin to make mistakes, Orlando points out. Their financial team has to have a good idea of the company's cash flows, and they can't rely on the income statement to provide that information.
Of course, having a good handle on cash also is critical for companies seeking outside funding from banks. For starters, just looking at revenue and operating expenses won't account for capital expenditures or for changes in inventory and accounts receivable and payable. CFOs need to understand these accounts to plot their organizations' financing needs.
Until a year or so ago, many financial executives could simply call their banker and extend their firm's line of credit if they found that their company's bank balance was coming up short. This is less likely to be successful now, says Fred Eisenhart, a San Francisco-based partner with the private companies services practice of PricewaterhouseCoopers. “If new sources of cash are needed, the lead time is longer and the likelihood of getting it is less.” At the same time, banks are more willing to call companies' bank debts when they violate loan covenants, he adds. Many covenants, such as the requirement to maintain a minimum level of working capital, relate to the balance sheet.
With commercial loans harder to come by, financial executives are paying greater attention to other tactics for freeing up cash, such as reducing inventory, more quickly collecting accounts receivable, or selling and leasing back assets. These steps all require a good handle on projecting the balance sheet and cash flow statement.
Along with bankers, at least a few investors also are spending more time scrutinizing balance sheet numbers and cash flows. One is Tom DiBella, chief investment officer with Turner Investment Partners in Berwyn, Pa. The income statement provides insight into the health of a company, while the balance sheet shows its wealth, he says. That is, the balance sheet indicates whether the company has the resources to weather tough times, which tend to depress earnings. DiBella says that he can add value for his clients by including the balance sheet, as well as the income statement, in his analysis of companies.
The dot-com implosion earlier in this decade highlighted the games that can be played with earnings. It was Enron's balance sheet, Player points out, that first signaled potential problems, as return on equity failed to keep pace with the earnings the company reported. Many financial executives, including those with private companies, are facing a greater scrutiny of all of their financial statements.
TouchStar Solutions, LLC, is a Tulsa, Okla.-based developer of mobile computers. Privately held, the company isn't bound by Sarbanes-Oxley, says chief financial officer, Keith Curlee. Even so, he and his team have been preparing budgeted balance sheets and cash flow statements for the past several years. “It makes business sense to do so,” he says. TouchStar has been growing at a triple-digit pace for several years. “If we're not careful, we can grow ourselves broke,” he notes, as working capital has to be in place and employees hired in advance of the growth.
ON THE OTHER HAND …
Not every company finds it worthwhile to spend a great deal of time and attention on balance sheet or cash flow numbers. SureWest Communications is a growing microcap telecommunications company that is currently expanding its fiber network, says Dan Bessey, chief financial officer with the Roseville, Cal.-based firm.
As a result, while Bessey reviews the balance sheet and cash flow statement, the main object of attention is the income statement. He and other senior managers particularly watch EBITDA (earnings before interest, taxes, depreciation, and amortization), growth in EBITDA, and EBITDA as a percent of revenue. “We want to see growth in EBITDA numbers and growth relative to revenue, to show that the company is growing efficiently,” Bessey says. In addition, because the company no longer is paying dividends, investors will be focused on share price appreciation; growth in cash flow and profitability will increase the company's value and thus its share price.
Given SureWest's need to expand its technology infrastructure, Bessey and his team also closely monitor the capital plan and its expected return. Capital expenditures on property and equipment have totaled more than $70 million annually for each of the past several years. They'll do a number of “what if” scenarios to determine the impact on financial performance if, for instance, the capital budget drops from $70 to $50 million.
As SureWest completes its network expansion over the next few years and becomes more mature, the focus will turn to free cash flow and other measures found on the balance sheet and cash flow statements. “Until we get to that stage, our focus is primarily on EBITDA,” Bessey notes.
BUDGETING TECHNOLOGY IMPACTS NUMBERS
At most firms, technology has made budgeting for all three primary financial statements more feasible. A range of software applications on the market now vary in price from several thousand to several hundred thousand dollars, says Cleveland Pendock, president with Pendock Mallorn Ltd., a provider of financial management software based in Port Hope, Ont.
Spreadsheets, although still the backbone of many companies' budgeting processes, quickly become unwieldy. It's not unusual to finish one statement only to realize that an omitted transaction will ripple through several other documents, notes Pendock. At the same time, the unstructured nature of spreadsheets also becomes a limitation, Houle notes. It's too easy to change assumptions or calculations without tracking what's been done.
On the other hand, most ERP and accounting systems tend to have too rigid a format. This can be an obstacle in budgeting, given that the objective is to think about the future and identify the ways in which the business will change. The goal is “the sweet spot” of a structured but flexible application, Houle says.
Monica Haas, vice president of corporate planning with Sempra Energy, San Diego, has seen the difference the right planning tools can make. Sempra prepares a five-year, full financial forecast of all three financial statements, using Hyperion Strategic Finance budgeting software. Employees also use a combination of spreadsheets and budgeting software for Sempra's one-year budget. Using an application specifically geared to budgeting dramatically reduces the time and effort required to put together the plan, Haas notes. Not surprisingly, Sempra is migrating its one-year planning process to the budget software, as well, she adds.
Once the technology is in place, just how does an organization budget for all three primary financial statements? Houle recommends starting with the income statement, as this captures the operating activity of the business. Also, most transactions that show up on the income statement will affect the balance sheet numbers. For instance, net profit flows from the income statement to the balance sheet. Of course, the changes resulting from the activity shown on the income statement need to be combined with the starting balances in accounts such as inventory and accounts payable in order to develop a budgeted balance sheet.
You want to build a financial model that links the number drivers between the various statements, says Rob Hull, co-founder and chief financial officer with Adaptive Planning, a provider of financial planning applications with headquarters in Mountain View, Cal. For instance, if you know that each new hire will require a laptop computer, this formula should be embedded into the capital plan, as well as in the asset account on the balance sheet and the depreciation expense on the income statement. Similarly, you include a formula for calculating budgeted accounts receivable from the average days sales outstanding (DSO), adds Hull.
Budgeting for all three statements requires a level of granularity, Houle notes. For instance, assume that a business has several divisions, each with its own set of customers. Customers in one segment pay more quickly than those in another. If management focuses on boosting sales in the segment with laggard customers, working capital will be impacted differently than if sales rise in a division whose customers pay promptly. As a result, simply taking an average increase in accounts receivable won't be accurate. Similarly, management at a capital-intensive business that is targeting a 10 percent overall return on assets may actually need to budget a 20 percent return at the subsidiary level, in order to cover the assets on the books at the corporate level.
However, you don't want the people doing the planning to become mired in detail, says Haas at Sempra Energy. “Planners can have a tendency to turn into accountants. We don't need an accounting-perfect forecast; we need a meaningful forecast.” However, simply stating that any transaction below a certain amount is immaterial may result in overlooking something that's of low value but still important, Haas says. So, if a Sempra employee seems to be spending an inordinate amount of time on an issue that appears to be low-value, he or she is encouraged to bring the item forward for discussion.
Another danger is that planners will assume that because they're budgeting in greater detail, they can better control the future, Player notes. Of course, this is not the case.
The goal is to design models that elevate the key business assumptions driving the financial statements. “Understand the key drivers of the business and their impact on business operations and resources and requirements,” Hull says. Management should be able to see how a change in one aspect of the business, such as the cost of raw materials, is likely to influence profitability, cash flow, and other key accounts.
Finally, involving operations in the budgeting process also is key. For example, sales people tend to focus on the income statement and on revenue in particular. However, they also should take responsibility for indicating when the revenue booked actually will be collected. “It's a transition from P&L responsibility to complete financial performance responsibility,” says Houle of Quantrix. “You need to look at this for a successful business.”
FINANCIAL STATEMENTS FOR CUSTOMERS
Sometimes it's not the board of directors, investors, or bankers that request budgeted financial statements, but customers. Companies preparing business cases for clients often find that including a projected balance sheet in their number-crunching can be beneficial.
This is the case at Gartner Lee Limited, an environmental consulting firm based in Markham, Ont. Andrew Keir, vice president of strategy management, uses Quantrix software to prepare financial analyses for clients on projects such as a water and sewer system privatization and the development of a new power plant. Gartner Lee's customers then provide these analyses to potential investors.
Many analyses cover 20 to 30 years, as most of these multibillion-dollar projects require that long a payback period, given the large initial investment. Investors have to be reasonably sure that the cash streams generated will allow them to recoup their investments.
Keir and his colleagues first complete a cash flow statement, estimating the flow of funds in detail over the first several years; after that, the assumptions become more general. This information provides the foundation for the income statement, including cost and revenue drivers. The last statement prepared is the balance sheet. “We're building fairly complex, whole-system models,” Keir says.
Over the past several years, Keir has noticed a growing emphasis on “understanding the cause and effect: how various costs and revenues behave relative to changes in trends, markets, and populations,” he says.