Balance Sheet Quality

Working capital can look perfectly healthy and still be partly fiction. The receivables ledger includes invoices from customers who went out of business two years ago. The inventory includes stock that has not moved since the product line changed. Revenue was booked when the deposit arrived, before the work was done. And somewhere outside the ledger there are bonuses promised and not paid, a warranty claim brewing, and a lease that will need to be bought out. None of it shows in the working capital figure, which is exactly why a buyer's quality-of-earnings team goes looking, and why each discovery comes off the price with a premium for the surprise.

Balance Sheet Quality makes the balance sheet behind working capital real: receivables that will be paid, inventory that exists and will sell, revenue recognized when it is earned, and every obligation a buyer will treat as debt listed before the buyer finds it.

Receivables that will be paid

A clean receivables ledger has only a small share of its balance more than ninety days past due, a written reserve policy drawn from three years of write-off history and applied, and a record of every write-off and who approved it.

The work is monthly and unglamorous. The ledger is aged every month, and the finance seat reviews every balance over ninety days with its reason and next action. Balances with no realistic prospect of collection are written off at the close. The reserve policy sets a percentage by age band, taken from three years of actual write-offs, reviewed by the outside accountant and applied every month, so that receivables appear on the balance sheet at what the business expects to collect.

From a receivables total alone, a buyer cannot tell how much will turn into cash. An aged ledger with a reserve drawn from the business's own history answers that with evidence, and the buyer has no gap to fill with a guess.

Stock that exists and will sell

Inventory needs a full physical count within the last year, observed by the outside accountant, with only a small variance from the books, and every item with no movement in a year reserved or written down under a written policy.

The count follows a procedure a buyer's accountant would recognize: count sheets, a cut-off at a stated date and time, recounts where the count and the books disagree, and the adjustments posted to the ledger. After that, a monthly report lists items with no movement in six months and in twelve. The twelve-month items are reserved under the policy and, where possible, sold, returned or scrapped, so that the stock on the balance sheet exists and will sell.

In the illustration, a business carrying $900,000 of inventory, of which 14 percent has not moved in a year and would fetch 30 percent of its cost, holds $88,000 of working capital that exists only on paper. A buyer will write it down. A business that writes it down first, and clears what it can, presents working capital a buyer can rely on.

Revenue recognized when it is earned

The revenue test is a written recognition policy, consistent with the statements, with every deferred revenue balance and customer deposit matched to the work still owed and its cost to deliver, and no revenue in the last three years recognized before the work was done.

The policy, written with the outside accountant, says when each type of sale counts as revenue, how deposits and prepayments are held, and how work spanning several periods is split. Every deposit and deferred balance is then listed with the customer, the work owed, the expected completion date and the cost to complete. A business that recognizes revenue before doing the work is borrowing earnings from next year. A buyer who finds that restates the earnings and starts wondering what else was brought forward.

Every obligation listed

The fourth piece is a schedule of every obligation a buyer will deduct from enterprise value as though it were debt, each listed and quantified from the ledger, with nothing found later in diligence missing from it.

The schedule is built by a sweep. The finance seat and counsel go through every accrual, every liability account, every employment and lease agreement and every open dispute, listing anything that will require cash after closing for value the business received before it. Each line carries an amount, its source in the ledger or the basis of its estimate, and the document that creates the obligation. The schedule is also a line on the month-end checklist, so a new obligation goes on in the month it arises.

Completeness is the whole point. A buyer moving from enterprise value to the price of the equity subtracts every item it finds. An item the seller listed is subtracted at the seller's figure, agreed in advance. An item the buyer finds is subtracted at the buyer's figure, often with something added for the trouble, and it changes how the buyer reads every other number in the file. That is why the test written into this work is that diligence turns up nothing the schedule left out.

Here is how the arithmetic runs. Take an illustrative enterprise value of $8.5 million. Subtract $1.2 million of bank debt and $380,000 of obligations on the seller's schedule, such as unpaid bonuses, customer deposits for work not yet done and a lease that behaves like borrowing, and the equity is worth $6.92 million, a figure both sides can agree on day one. Now suppose the buyer's lawyers find a $150,000 warranty exposure that was not on the schedule. The price falls by at least that amount, to $6.77 million, and in practice often further, because the buyer adds a margin for having found it, may ask for an indemnity against anything similar, and reads every other figure in the file with less trust.

What it does to value

The framework separates this driver's effects carefully. Cash recovered counts as value: old receivables collected instead of reserved and forgotten, slow stock sold instead of written down and kept. So does risk removed, since the chance that an undisclosed liability surfaces after the sale falls toward nothing once every obligation is on the schedule.

Removing the buyer's haircut does not count. A business that reserves its own doubtful receivables and slow stock recovers no cash by doing so; it simply presents the balance sheet a buyer would have arrived at. Moving an obligation from the buyer's number to the business's own, with the obligation unchanged, is the same. Those are effects on price and certainty, recorded separately, and they are why the driver ranks sixth on the bridge.

What has to be in place first

The working-capital definition from Working Capital Management decides which balances are working capital and which are debt-like, and both schedules are built from that one assignment of accounts. The close calendar from Books matters because ageing, slow-stock reporting and the debt-like schedule are close tasks, and without a fixed close they get done once and never again. And the outside accountant and counsel have to be engaged for the count, the policies and the sweep, budgeted alongside the review engagement and counsel's existing work on the liabilities file.

Knowing that it works

The measures are receivables over ninety days as a share of the total, monthly; inventory with no movement in twelve months, in dollars, with the share of it reserved; and obligations found outside the schedule, counted each quarter at the close reviews, with a target of none.

An owner who knows the balance sheet can name the five oldest receivables and what is being done about each, from the aged ledger, before the finance seat is consulted. The stronger proof is the schedule of debt-like items: the owner reads it, adds anything missing, and signs it as complete, which is the same statement a purchase agreement will ask the seller to make.

Why it slips, and what holds it

Obligations that behave like debt pile up off the schedule, one promise or one claim at a time. And working capital fills with stale stock and dead receivables carried at full value.

Ageing, slow-stock and debt-like reviews are fixed lines on the close checklist, and a named seat has to sign them at every close, which catches a new obligation in the month it arises. An observed inventory count and a reserve review every year write down stale stock and dead receivables annually, before a buyer has the chance to find them.