Most recruitment business owners spend very little time thinking about the Balance Sheet.
That is understandable. Performance is usually measured through the Profit and Loss statement. Revenue, gross profit and operating profit naturally attract attention because they are the measures most used to judge performance.
But stewardship of a business involves more than the Profit and Loss statement. Over time, profits create choices. Those choices shape the Balance Sheet. And eventually, particularly when a sale transaction is contemplated, the Balance Sheet suddenly becomes very important.
This article is not intended to educate from an accounting perspective. Rather, it is intended to explain why the Balance Sheet deserves attention and why Working Capital can influence shareholder outcomes.
Profit Creates Choices
The first is to build financial strength. Owners may decide to preserve cash, reduce debt or strengthen the working capital position of the business.
The second is to invest for the future. Investments in technology, people, acquisitions or expansion may all improve the long-term prospects of the business.
The third is to create wealth for shareholders, usually through dividends or other distributions.
There is no single correct answer for how profit is allocated to these three broad areas. Different owners and different businesses make different decisions. But over time those decisions shape the Balance Sheet.
Wealth Accumulates on the Balance Sheet
Strong profits, disciplined use of capital and careful stewardship often create financial strength. Equally, poor decisions or excessive or poorly targeted debt can weaken the business.
Many owners pay little attention to the Balance Sheet because the business continues to trade successfully. It is often only when a sale transaction is contemplated that they realise the Balance Sheet contains information that matters to shareholders.
Understanding Working Capital
Clients need to be serviced, payroll needs to be funded, and creditors need to be paid. Even those using the simplest cash management reporting see the ebb and flow of cash in the business. In some businesses, particularly those using debtor finance, additional complexity is introduced through funding arrangements.
As a result, a certain amount of working capital is required simply to allow the business to continue operating.
This is where some owners become surprised: not all the cash and assets sitting inside the business necessarily belong to the shareholders. Some of those resources are required to support the ongoing operations of the company.
Excess Working Capital
However, some businesses accumulate assets or cash beyond what is required to support normal trading. This excess working capital may represent additional wealth available to shareholders.
Not always, and not automatically.
But understanding the distinction between required working capital and excess working capital can have a material impact on a shareholder’s bottom line in a sale transaction.
Some common terms
In simple terms, enterprise value represents the value of the operating business itself. It does not necessarily include surplus cash, excess working capital or borrowings. Those items are considered separately.
This distinction explains why the amount eventually received by shareholders may differ from the enterprise value discussed during negotiations.
Another expression that frequently appears is “cash free, debt free”.
It sounds mysterious, but the principle is relatively simple. The buyer is purchasing the operating business. Surplus cash and debt are dealt with separately. This approach allows both parties to focus on the value of the underlying business while addressing the Balance Sheet independently.
Of course, life is rarely that simple. Debt facilities, overdrafts, debtor funding and loan arrangements can all influence the final outcome and add complexity to the discussion.
Don’t ignore the Balance Sheet
Working capital may not be the most exciting topic in business. It is certainly not the topic that attracts the most attention, but understanding the Balance Sheet and the concept of working capital can make a significant difference to shareholder outcomes.
Most transactions require a minimum level of working capital to remain in the business. It is the excess working capital that may represent additional wealth available to shareholders.
And while owners naturally spend most of their time discussing profits, the Balance Sheet deserves attention because wealth is accumulated there over time.
This article is part of HHMC’s Appropriately Corporate series for staffing and recruitment business owners, exploring growth, leadership, valuation and transaction readiness. If these issues are relevant to your business, we would be pleased to continue the conversation.
