July 2018    
Volume 10, Issue 7    

The Anatomy 
of Financial Statements: 
Part 4 of 4
Balance Sheet

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In our previous newsletter, you learned about the Cash Flow Statement. Now you know how much is in your bank account at the end of the reporting period and why it is that amount. It's time to look at the balance sheet. Remember that the P&L and the cash flow statements measure a time frame, such as from January to December, or the first of the month or quarter to the end of the month or quarter. Everything that has happened between those two dates is summarized and reported. The balance sheet is different; it is measured from a single point in time, like taking a picture or snapshot. The balance sheet's numbers are cumulative, so the numbers reported are from the first day the practice opened its doors, until the date of the reporting period you are measuring.
The categories on the balance sheet measure assets, liabilities and equity. The balance sheet gets its name because the total amount of assets must equal, or "balance", the total amount of liabilities + total equity.
In the first section, the asset section, accounts are listed in order from the most liquid (easily converted to cash) to least liquid, so the first number on the balance sheet is the amount of cash in your bank accounts (which, remember, was also the last number on the cash flow statement). The asset section also includes accounts receivable (the amount that clients owe you), inventory (the dollar amount of products and drugs sitting on your pharmacy shelves), fixed assets (large medical equipment such as ultrasounds, X-ray machines, computer equipment, furniture, etc.) and intangible assets (goodwill, covenants, etc.)
The second section of the balance sheet shows liabilities, which are listed in order of when the liabilities are due, or "payable". For example, current liabilities are amounts that are due in less than a year, which include normal operational accounts payable such as utility bills, along with credit card balances. Long-term liabilities are amounts that are payable in full in a year or longer, such as equipment loans and mortgages.
Equity is the last section of the balance sheet. This is the investment you, as the owner, have made over the life of the practice. The equity section includes the cumulative net profit or loss from each year minus the money you have taken out in draws or distributions, plus any money you have reinvested into the practice.
The balance sheet totals assets and subtracts all the liabilities to calculate the equity. You may also hear equity referred to as overall net worth; however, this number is not to be confused with the current value of your practice. That is a whole different enchilada for another article. Equity can be called by several different names, depending on the organizational structure of the practice. For Sole Proprietors, it is referred to as Owner's or Proprietor's Equity. In a Limited Liability Company (LLC), it is labeled as Member's Equity. Corporations call it retained earnings, which illustrates a better description of what it truly measures, the earnings the practice has retained over its lifetime. Bringing it home, the last number on the balance sheet represents the blood, sweat and tears you have put into your practice. If equity is positive, it means that the practice has been profitable in the past and you have left a portion of that profit in the practice. If equity is negative, it indicates that either you have been operating at a loss or have taken all of the profit out of the business, and then some.
Several third parties, such as bankers and potential buyers, use ratios from the balance sheet to evaluate the financial strength of the business. Some useful analytics from the balance sheet include how long it takes you to generate enough cash to pay your bills within the vendor's terms, and how those two numbers relate to each other from the standpoint of the operating cash cycle. A useful ratio is the Current Ratio, also known as the working capital ratio. This ratio divides current assets by current liabilities and is mainly used to give an idea of a company's ability to pay back its liabilities with its assets. For example, if a practice has current assets of $550,000 and current liabilities of $450,000, the ratio would be 1.22 ($550,000/$450,000). A ratio higher than 1 indicates that the practice is capable of covering all its debt within the time frame it's due, so this example would be favorable. Another helpful ratio to use is the Inventory Turnover Ratio, measuring how well a practice generates sales from its inventory. Managing inventory levels is vital since it can show whether your prices are sufficient and if costs are being controlled properly. Inventory turnover is the number of times a company sells and replaces its inventory during a period (usually a year) and is calculated by dividing total purchases by average inventory. Average inventory is the beginning inventory plus ending inventory, divided by two. For example, in a practice that spends $800,000 on pharmaceuticals and supplies and has an average inventory value of $80,000, the turnover is 10 turns per year. The higher the inventory turnover number, the better since this means inventory is not stacking up on your shelves. However, if inventory turns over too quickly, the risk of product shortages increases. Dividing the number of turns into 365 days will give you the number of days of inventory is on hand. So this example would be 36.5 (365/10 turns) days of inventory is on the shelf.
To summarize our Financial Anatomy series, the profit and loss statement tells you how you are making profits, the cash flow statement tells you how much of those profits you are keeping in cash, and the balance sheet tells you how you use the cash you get to keep. Your practice's financial statements tell a story; you simply have to read the pages in the right order and understand the language. Now you can understand the big picture of what has happened in the past, what is happening now, and what could happen to your practice in the future.
When you review your practice's financial statements holistically, you can make smarter financial and managerial decisions for your practice. Of course, that's easier said than done in many situations, so be open to asking for help - whether from an accountant, consultant or other resources. Getting your head wrapped around your practice's financial data may be the most important thing you do this year!

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