April 2001 Bulletin

Balance sheets deciphered

Basic understanding can help practice decision-making

By Janice G. Cunningham

As with any business, you must monitor the financial indicators in your orthopaedic practice. Routine analysis of practice financial statements may help you identify potential problems before they become insurmountable. You may also determine which investments in the practice have paid off and which might best be scrapped. Your financial statements may guide you toward new investment areas within the practice. You may also be alerted to problems before they become insurmountable.

Many physicians believe one must be an accountant to understand financial statements. That is not true. By understanding some basic concepts, you will be able to use the information on your statements to help in practice decision-making.

Accrual vs. cash accounting

Most small to mid-sized orthopaedic practices use the cash basis of accounting to prepare their tax returns and financial statements. Larger organizations tend to use the accrual method of accounting.

In cash basis accounting, income is recorded as it is received. Likewise, expenses are recorded once they are paid. Liabilities, such as the outstanding balance on a loan, are shown as the actual value of the balance still owed.

The accrual method, on the other hand, records income at the time the practice earns the right to receive payment. Expenses are recorded on the day they are due. In both cases, it does not matter whether the money was actually received or paid out on the day in question. Rather, the books show what was due to be paid into the practice or out as of the date of the statement. Adjustments are done periodically to reflect things like bad debt and other write-offs.

The differences become important if you are comparing your financial performance to the standard ratios discussed in more detail below.

Components of financial statement

Financial statements contain two key elements: the balance sheet and the income statement. Your accountant may also include other reports such as cash flow analyses.

Balance sheet. The balance sheet is a "snap-shot" of your practice’s financial situation at any one moment in time. It will change from day to day, month to month and year to year.

The balance sheet starts by listing the practice "Assets." These are generally broken into broad categories such as cash accounts, furnishings and equipment, notes receivable and miscellaneous. Equipment values are generally shown at the depreciated value.

Accounts receivable, pre-paid short-term expenses and other short-term payments due to the practice are generally not shown on a cash basis balance sheet. Assets that are expected to be realized before the next annual financial statement, such as these items, are also called "Current Assets." If you see an entry for accounts receivable under the assets section, you are probably looking at an accrual basis balance sheet.

Next on the balance sheet are the "Liabilities." These generally include loan amounts due from the practice and other debt.

A cash basis accounting usually does not include short-term liabilities such as accounts payable, payroll earned but unpaid and retirement plan contributions accrued but not yet made. Such liabilities that are expected to be paid in full and therefore come off the balance sheet before the next annual financial statement is prepared are also called "Current Liabilities."

Accrual balance sheets show all liabilities as of the date the debt attached. Hence, payroll would accrue for each day employees work, even though paychecks may not be issued until a week or two later.

The last section on the balance sheet is the "Equity" section. Many consider this the net worth of the practice. The total value of the Assets minus the total value of the Liabilities equals the Equity. If your Assets are worth more than your Liabilities, you will have a positive Equity value. Conversely, if your Liabilities exceed your Assets, you have negative Equity.

Your accountant may break the Equity section into a few categories, including capital stock and retained earnings.

Income Statement. The income statement, also referred to as a "profit and loss" statement, records the practice’s income and expenditures. Like the balance sheet, the income statement gives you a snapshot at any given moment and is constantly changing. Unlike the balance sheet, the income statement covers a specific period of time and shows the results as of the last day of the measured period. Most practices prepare annual income statements. You should also consider reviewing monthly income statements that show the results for a given month and the year to date totals.

The first part of the income statement records income. For cash basis practices, it shows actual cash received during the measured period and deducts any refunds paid out. Income may be broken into categories. Typically, medical practices show patient revenues and interest income. Some further delineate patient revenues into payer categories such as "revenue from Medicare," "revenue from workers’ compensation" and the like.

An accrual basis accounting shows income as soon as you deliver the service, even though you may not get paid for weeks on the claim. It would also show income based on your charges and then typically has an adjustment entry for contractual and other write-offs.

The second section of the income statement shows all money paid out during the measured period. Expenses are divided into broad categories. These delineations are determined at the time you set up your books and may be as detailed or broad as you wish. Most practices at least record staff salaries, benefits, retirement plan contributions, occupancy costs, medical supplies, office supplies, and the like.

Other Financial Reports. Most practices prepare other financial reports in addition to the balance sheet and income statement. These may include cash flow analyses, bad debt reports and aged accounts receivable. Of key importance for a medical practice is the aged accounts receivable report.

Analyzing your statements

Balance Sheet Ratios. There are a few quick analyses using the balance sheet you can perform to monitor your practice’s financial situation. If your balance sheet is prepared using the cash basis of accounting, you will first need to make a few adjustments.

First, add in the value of accounts receivable (net of bad debt and contractual adjustments) and pre-paid expenses as Current Assets. Next, include any accounts payable and accruals for payroll, retirement plan contributions and payroll taxes to the Current Liabilities section.

You may then consider the operational ratios on liquidity and debt management.

Income statement. Most practices review an annual income statement representing all income and expenses for an entire year. While this is useful, it is far better to review interim statements representing monthly income and expenses. In this way, you will be better able to identify negative changes and make the necessary adjustments.

Liquidity–ability to use current assets to meet current debts

Name

Measures

Expression

Range

Current Ratio

Ability to turn all current assets to cover current debts

Current Assets divided by Current Liabilities

1.75-2.0

Working Capital

Ability to cover monthly expenses

Current Assets minus Current Liabilities

At least 1.5 months of expenses available

Debt management–ability to leverage debt

Name

Measures

Expression

Range

Debt-to- Assets Ratio

Asset ability to cover debts (asset borrowing leverage)

Total Debt divided by Total Assets

.5

Debt-to- Equity Ratio

Whether practice is over- or under- leveraged

Total Debt divided by Total Equity

1

On a monthly basis, a cash basis accounting may be deceiving. Take malpractice insurance, for example. Suppose your practice pays the malpractice insurance premiums on January 1 to cover the entire year. Your January monthly income statement will show a huge expenditure for malpractice insurance. However, each succeeding month’s income statement will show no expense for malpractice insurance. You have essentially pre-paid for a year’s worth of insurance. However, the balance sheet would probably not show this pre-paid expense as a "Current Asset."

Compare that with an accrual basis monthly statement. The premium would be recorded as a pre-paid expense on January 1 on your balance sheet. On the income statement, one-twelfth of the total premium would be recorded as an expense on each monthly statement. In each succeeding month’s balance sheet, the value of the premium as a pre-paid expense would be reduced by one-twelfth.

When you set up monthly income statements, include columns for the current month and current year-to-date. For comparison, you should also include columns for same month last year and last year’s year-to-date.

Also consider cost accounting by business line. For example, if your practice has a physical therapy department, pull out income and expenses for therapy into a separate income statement. This allows you to measure the profitability of each line of business.

Much has been written lately about benchmarking your orthopaedic practice against industry averages. Please see the October 2000 AAOS Bulletin for more information.

Profitability

Business (Common Ratios)

Name

Measures

Expression

Range

Net Profit Ratio

Dollars to providers from dollars generated

Net income available for owner income divided by Net Revenues

.45—.55

Overhead Expense Ratio

Measures costs of being in practice

Operating expenses divided by Net Revenues

.45—.55

Return on Assets Ratio

Measures Effectiveness of "Hard Assets" in generating incomes

Net income available for owner income divided by Total Fixed Assets*

Varies

* Includes equipment, etc. Excludes current assets

Efficiency–ability to generate cash income

Work Effort

Name

Measures

Expression

Range

Average Daily Billings Ratio

Work output

Net Billings* divided by 365 Days

30-60

Average Collection Period Ratio

Average days billings outstanding and turnover of same

Accounts Receivable divided by Average Daily Billing

30-60

A/R Ratio*

The number of months of collections, tied up in accounts receivable

Adjusted Accounts Receivable divided by Average Monthly Collections

1-2

Net Collection Ratio

Efficiency in collecting "realistic" net charges

Collections* divided by Net Charges**

95-100%

*After bad debt and contract adjustments

**Net of Patient Refunds

*** Gross charges minus contractual adjustments

Accounts receivable. Your accounts receivable reports contain a wealth of information. It is best to monitor the information on a monthly basis over a period of time. Note any trends you see in ratios on profitability and efficiency.

Your orthopaedic practice is much like any other business when it comes to understanding and using financial information. Even though your administrator, accountant and other advisors may be charged with managing the practice finances, the physicians as owners must have an understanding of the financial statements and reports. The analyses are simple to calculate and may help physicians ask questions and resolve problems before they become too far gone to remedy.

Janice G. Cunningham, is a consultant and attorney with The Health Care Group® and Health Care Law Associates, P.C., based in Plymouth Meeting, Pa.


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