Manage Money : Good Financial Management – Rule 1

In the previous issue we had discussed what a Profit & Loss Account is, what it contains. In this article let me dwell a bit on the Balance Sheet.
...continued from previous issue

We have been discussing, in previous issues, the first rule of Good Finance Management, which stipulates that a business should generate on its investment a return which is at least equal to its cost of capital. We had calculated the weighted average cost of capital (WACC) at 16.8 per cent. In the Balance Sheet that we had considered the total capital was 1000 and at 16.8 per cent the cost of capital in absolute amount worked out at 168. And the investment of 1000 would accordingly be justified only if the assets deployed could earn for the organisation a return of 168. Stop for another minute and think. Do all assets generate income? No, they do not. If you make a list of all the assets a business typically possesses (land, buildings, equipment, vehicles, furniture, stocks of raw material, fittings and fixtures & so on) you will find that it is possible to classify all assets into two types: Performing Assets (PAs) and Non-Performing Assets (NPAs). Every organization is bound to possess assets which can be called NPAs. By non-performing, I do not necessarily mean non-essential assets or those not required. NPAs are those assets that do not directly generate income for the organisation. The furniture in your office, for instance, is essential but does not generate income. Some assets earn for the organization, while others do not.

Let us assume a break-up between PAs and NPAs of 50:50. There will be organizations with a better PA vs NPA ratio, while there will be others with a worse ratio. Now how does this change the equation? Going back to our example, the minimum return we required to generate was 168 on an investment of 1,000. However, since 50 percent of the assets are NPA, it is only the remaining 500 worth of assets that are expected to generate 168. This now takes our targeted rate of return to 33.6 per cent. Now think about whether your PAs perform for all 365 days in the year. Many organizations follow a five-day week. And counting national holidays and festivals, and break-downs and maintenance-related shut-downs, and taking leave entitlements into account , it has been estimated that even PAs effectively perform for two-thirds of the year. Liabilities, however, perform throughout the year! No banker, while lending, offers not to charge interest for the weekend. So, considering that our assets are supposed to generate a return of 33.6 per cent, which has to be achieved over two-thirds of the year (since for the remaining one-third they are NPAs), the effective targeted annualized rate of return now goes up to 50.4 per cent. If you are an entrepreneur who is reading this and realising these truths for the first time, I’m sure you will not sleep tonight! This organization will now have to earn at the rate of 50 per cent plus in order to meet every stakeholder’s expectations. My purpose in detailing and dissecting matters is to drive the message that every asset has a corresponding liability, and every liability has a cost. If all your assets are performing, and if the cost of your sources is, say 10 per cent, your assets must generate a return of 10 per cent. However, if half your assets are NPAs, the PAs must earn at 20 per cent. If the PAs perform for two-thirds of the year, they must generate a return of 30 per cent. Now, let’s consider the case of a household with a family of ten members and a monthly expenditure of 100,0000. If all members were to work, it would be the obligation of each to contribute an amount of 10,000 towards household expenses. However, in a family of ten some are likely to be too young and some too old to work and earn. If five are NPAs, each PA will have to contribute 20,000. Whenever there are NPAs, the expectation from the PAs become that much higher. Higher the NPAs, bigger is the burden on the PAs to perform for themselves and for those who don’t perform. One significant way in which organizations can improve their profitability is by improving the proportion between their PAs and NPAs.

India might have lost Every asset has a corresponding liability, and every liability has a cost

Every asset has a corresponding liability, and every liability has a cost We must note that every investment in excess of the optimum level is non-performing. Holding inventory is necessary for a manufacturing organization–but inventory in excess of what is required is a non-performing asset. It may be the norm to extend credit to customers-but if the salesperson offers customers 45 days credit, when with a little negotiation he or she could have managed to sell on 30 days credit, the excess of 15 days is non-performing. Cash-in-hand beyond what is necessary is a NPA. manage money

Balance Sheet

By Dr Anil Lamb