For this series of articles, the goal has been to address managing a practice from a diagnostic perspective. Just as a veterinarian evaluates the patient from a foundation of known facts, a strong understanding of the business facts, in the right format, offers the practitioner the foundation to diagnose the financial health and current status of the business. Management accounting (accrual) books help the practitioner utilize the financial reports to make better, proactive business decisions.
As we continue to follow our new practitioner in his quest to build an equine practice, we started with the Cash Flow Statement, moved to building a functional Income Statement (Profit and Loss or P&L Statement), and we now turn our attention, in this final article on Financial Statements, to the next report: The Balance Sheet.
Using our new practitioner’s business as an example, we will define his Balance Sheet, its relationship with the P&L Statement and figure out the management information (the diagnosis) that our new practitioner can derive from his financial report.
The Balance Sheet is a listing of the Practice Assets (money, property, equipment, inventory, money owed to the practice by clients, etc.) and a listing of all of the Practice Liabilities (money owed to others for products, equipment, inventory, etc.). The difference between the two is the owners’ Equity (positive or negative), which is the claim the owner of the business has on all of the assets in the event that he or she would sell (liquidate) everything at a given point in time. Equity is also known as Net Worth.
It is best to think of this report as a snapshot in time illustrating the financial position of the business. This report paints a picture of the practice’s short- and long-term activities regarding what the practice owns, what it owes and what is left over for the ownership at the end of the day.
The Profit and Loss Statement (P&L), on the other hand, captures the total revenue less the cost for goods, less overhead costs and operating expenses, equaling either a profit or loss our practitioner recorded over a specific period of time. (See previous articles on Income Statements in the spring and summer 2013 issues of EquiManagement and online at EquiManagement.com.)
For example: Our practitioner’s P&L unfortunately showed a loss of $3,128 and his Balance Sheet showed a negative equity ($526), but our practitioner could just as easily have had a profitable month and still shown negative equity on the Balance Sheet. This is because the Balance Sheet takes into account more than the monthly revenue and expenses in the P&L records. That is why in this practice, the Balance Sheet illustration of a negative Equity number does not match the monthly P&L. The differences will be defined as we move forward.
Figure 1 depicts our practitioner’s first Balance Sheet. Let’s walk through the line items listed, keeping in mind that the Balance Sheet reports three main items: that which is owned (Assets), that which is owed (Liabilities) and what is left (Equity).
Assets – Liability = Equity
Cash is simply money in the bank. It can also be publicly traded stocks and bonds, as well as money in a money market account—basically anything you can turn into cash in a day.
Accounts Receivable is the amount of money clients owe the practice. The practice “owns” this client obligation. In this example, the line item “reserve for bad debt” is the accountant’s best guess of what clients owe you that probably will not be paid. The accountant determines this number by utilizing his experience and discussing which clients may have difficulty paying.
Inventory in this case is simply the cost of products the practice purchased for re-sale or administration that have not been used (expensed); in other words, you have them in your possession. The thing to remember is that inventory is purchased with Cash. Having inventory that does not sell within a 30-day period will cost the practice money and is a poor use of Cash.
Pre-Paid Expenses are just that: costs that have been paid in advance. Insurance is an example of an expense that is usually pre-paid. These are still considered assets because they have not been consumed or used.
Notes Receivable are the receipts of payments on any outstanding notes (loans) the practice has issued. For example, the practice owner or an employee might borrow money from the company from time to time. That money is owed to the practice and would be categorized under Notes Receivable. It has value to the practice and is thus an asset.
Fixed Assets are all of the buildings, machinery, trucks, computers and every other physical asset the practice owns. The amount listed on the Balance Sheet is the cost of the item when it was purchased, less the amount that the item has been depreciated. Depreciation is how you define over time the “useful life” of something, whether it is a computer or a vehicle. When you depreciate something, you slowly reduce the value of that Asset down to zero based on the IRS tax codes. This is an important part of personal and business tax planning. Just as a vehicle’s value is less over time and use, so are all of the assets owned by the practice. This value also decreases due to fact that newer and better products are always entering the market at higher values.
Goodwill (aka Blue Sky) is generally found if the practice has been purchased, or after an additional practice has been purchased. It is simply the difference between what was paid for the practice and what the physical assets of the practice are worth. Mergers, Acquisitions and Consolidations are all the same; a value is established for the assets less the actual purchase, acquisition or consolidation price. This is called Goodwill.
So in looking at the Assets portion of the Balance Sheet, the key is to honestly record the value of what the practice owns, as well as understand how depreciation balances against actual usage. For example: If the practice purchased an expensive piece of equipment or machine with the anticipation of generating $1,000 per month in revenue, but the monthly depreciation (the diminishing value of the machine) was booked at $2,000 per month, the value of the machine is being reduced at twice the rate of the machine’s ability to generate income. The Balance Sheet would show the value of the machine at less than its ability to generate income and possibly reduce the value of the equity of the practice, or from the Banker’s point of view, reduce the practice’s ability to pay off debt. This is not an easy concept to grasp; we are mixing tax planning strategies with management strategies within the financial statements. It is important to understand how others view your business especially when looking for financing.
Liabilities
The second portion of the Balance Sheet is a list of the practice’s Liabilities, which are the financial obligations the practice has to others—or, put more simply, what the practice owes.
Accounts Payable is the amount of money the practice owes to its vendors. This is the exact amount owed on the date of the Balance Sheet.
Line of Credit is the outstanding amount owed to your lending entity on this loan on the date of the Balance Sheet. Because it is a short-term note, meaning it is due to be paid back within one year, it is labeled as a short–term liability.
Sales Tax, Payroll Taxes & Accrued Wages are the amounts owed for sales and work performed as of the Balance Sheet date. For example, if the Balance Sheet date is the end of the month and the payroll and tax payment dates are on the 15th of the following month, those amounts are “accrued” and listed here because they have yet to be paid.
Current Portion of Long-Term Debt (note) is the amount owed as of the Balance Sheet date. This might be a mortgage or equipment loan.
Long-Term Debt is the total amount of a loan to the practice. It is listed in this column after you take out the short-term portion of the loan. For example, our practitioner owes $130,000 on a piece of equipment and has paid $12,000; the remaining Long-Term Debt is $118,000.
Deferred Revenue is one line item that is not listed as one of our practitioner’s liabilities. Since this is a new practice, our practitioner will likely not have collected payments for future services and the Balance Sheet will not list items that are “0”. Deferred Revenue would be collected money for either services and/or products that have not yet been delivered. It is a liability because we owe the client something for the money received. For example: if you have an annual prepaid wellness program in which the client pays a fixed fee prior to receipt of any services (such as vaccinations, dental exams, etc.) that you have agreed to deliver during the remaining year, this revenue would be included as a liability to the business.
Equity
This brings us to the final of the three components of the report: Equity. The business term Equity, also referred to as Capital or Net Worth, is the section that records investment funds and/or distribution of funds to the owner(s). This is simply the sum of Assets less Liabilities, which equals Owner Equity (or Net Worth).
Capital is the value of your company based upon the value of everything the company owns, less everything the company owes. In our example (Figure 1), our Practitioner’s Practice has a negative Equity value of $526. It is not uncommon for a Practice to have a negative value, which means the Practice owes more money than it has in assets, or it has yet to generate enough revenue to cover expenses to date. In many practices, this number is close to zero because the business removes all of the profits on the Income Statement bottom line by year’s end either for tax purposes, to pay bonuses, etc. In short, the activity of any business builds profit (P&L bottom line) and if not used, it transfers as value to the Equity section of the Balance Sheet at a given point in time.
What the Balance Sheet Tells Us
Now our practitioner has a reasonable understanding of how both the P&L Statement and the Balance Sheet work. But as our practitioner begins to manage his practice’s profit and loss details, one of the best-kept secrets is that when there is a change in one statement, it will almost always have an impact on the other statement! Let’s take a quick look at a few real-life scenarios that illustrate this point.
Every sale recorded on the P&L Statement will generate an increase in Receivables or Cash on the Balance Sheet. A purchase of pharmaceuticals adds to accounts payable. Every dollar added to Cost of Goods (COGs) and/or Operating Expenses will subtract a dollar from the Cash line or add a dollar to the Accrued Expense line of the Balance Sheet. Our practitioner’s goal is to increase profitability, which, as we have seen, increases Equity. Unfortunately, it isn’t that simple. Our practitioner need to understand how those profits may have been earned.
Example #1: If our practitioner is offered a great deal on pharmaceuticals and decides to purchase a year’s worth, this may appear to be sound business, but it is? First the Inventory and Accounts Payable lines of the Balance Sheet will increase. Also, the practice will eventually use Cash to pay the Accounts Payable, likely months before the pharmaceuticals are sold, so there will not be a corresponding Sales increase. This could result in the practice needing to borrow cash to cover the payments, and there might be additional climate-
controlled storage costs.
Example #2: Our practitioner is looking to build his client base as quickly as he can, so he decides to target a specific group of horse stables. He believes this is a great idea because they appear to be welcoming him with open arms. If these accounts are slow or bad-pay clients, this will impact his Profitability and the Cash Flow of the business. Often they are welcoming because they have burned bridges with other practitioners in the area. How would this affect the practice financials? Answer: It will cause Accounts Receivable to rise and the Bad Debt Allowance to increase, which will reduce Profits, Assets and eventually Equity. But, armed with this knowledge, our practitioner might consider increasing the practice’s margins to compensate for the credit risk, demand payment at time of service, or other options to reduce the potential risk.
Take-Home Message
The information in the Balance Sheet helps the practitioner understand the effects the Income Statement has on operations and provides a measurable picture of the health of his practice. The chart at right (Quarterly Analysis) is an example of a group of management metrics (25 points) that are derived from the financial statements. Unfortunately it is outside of the scope of this article to go into these management reports in detail.
This chart illustrates opportunities to expand your accounting and business knowledge. Seek out professionals in your area to help you expand and understand new business terminology, reports and management metrics.
Business management is no different than learning a new language, as we all have done when becoming equine practitioners (learning medical terms).
On a personal note, one of the best classes I have taken (Accounting 101) has been at a local technical college. It’s a great journey and an adventure to learn, but challenging without the foundation of core accounting knowledge.
In this series of articles it appears that our new practitioner might need to change a number of practices if he wants a profitable business in which he builds Equity. Armed with this knowledge, proactive management decisions can be made to build this practice for the future. It all starts with accurate financial reporting and an understanding of what the reports tell you about the operations and value of the business over periods of time (trends) and at specific points in time.
References: EquiManagement
Spring 2013—Cash is King
Seasonal changes in cash flow need to be managed.
Summer 2013—Income Statements, Part 1
Fall 2013—Income Statements, Part 2
You need to understand the basics of your Income Statement to
help you understand your business.
