Understanding Financial Statements.

IN THIS COLUMN...

In his premier column for The Physician Executive, David Tarantino takes a look at those critical "financials" that can make or break a business. If you're considering a career move, you need to know the financial condition of future employers. Learn how to read the statements and glean valuable information from the numbers.

While medical school and residency training prepared me to care for patients, little was done to prepare me to practice medicine.

Today's physicians must understand basic business principles and the marketplace. While physicians talk frequently about examining the "financials," few in my experience have a true understanding of what financial statements are, how they differ, and what useful information can be obtained from them.

Before buying a home, it is best to have a house inspection to ensure that the structure is sound and that the heating, cooling, and electrical systems function properly. In much the same way, before committing yourself to any practice or business venture, take the opportunity to examine the financial architecture and soundness of that practice.

The first financial statement to examine is the balance sheet.

On a balance sheet, the left side of the document, represented by total assets, must equal the right side of the document, represented by total liabilities and equity. The most important point to remember is that the balance sheet gives a snapshot of the overall financial condition of a business.

At the top left of every balance sheet is a listing of the current assets. This section is important to determine how much cash is available for use, what the outstanding accounts receivable balance is, as well as any inventory the business may have.

Knowing about the cash and account receivable balances allows you to determine how quickly money comes into the business. Inventory does not generate revenue unless it is sold or used. So the amount committed to inventory should be low, especially for medical practices.

Property, plant, and equipment also may be referred to as long-term assets. It is important to know what assets a medical practice owns. If you buy in to the practice as a partner, you will need to know what the assets are and what they are worth.

The top right portion of the balance sheet examines the debt structure of the business, listing both short-term and long-term debt. The lower right portion lists any retained earnings the business may have, as well as any outstanding stock.

The income statement or profit and loss statement is the most recognized and easily understood of all the financial statements.

This is the document most people refer to as "the financials." It subtracts the expenses from the revenue to determine if there is a profit or loss. The last line of the statement indicates whether the business was profitable or not. It's truly "the bottom line." By accounting convention, any loss is noted by placing parentheses around the numbers.

The next two obvious components are the revenue and expenses. They tell you what the business collected and what it cost to get those collections. Several abbreviations: EBDIT refers to earnings before depreciation, interest, and taxes. Likewise, EBIT and EBT refer to earnings before interest and taxes are subtracted.

The cash flow statement allows you to examine how much cash is available, as well as the sources and uses of cash.

In the cash flow statement, three sources of cash flow are examined.

Cash flow from operations

This includes the net income as derived from the income statement, as well as changes in assets and liabilities. By convention, numbers with parentheses represent cash outflows. Those without are cash inflows. For example, the accounts receivable balance (what others owe you) is considered cash outflow, since you do not possess the cash that is owed to you. Likewise, accounts payable (what you owe others) is cash inflow, since you are holding that cash until you pay your bill.

Cash from investing

This is an outflow if you purchase new investments, an inflow if you sell them.

Cash flow from financing

This includes any cash obtained from long or short loans or the sale of stock. Any pay-off of debt or dividend payment is an outflow.

The bottom line of this statement may be more important than the bottom line of the income statement since it allows you to see whether the change in cash has been positive or negative. A negative trend in cash flows over a series of years is not a good sign for any business.

Financial analysis

Now that you know the elements of the three financial statements, it is important to examine how we can gain important information from them. A simple approach is to use what I call the "DOC" analysis. This analysis examines three important components of the structure of a business: debt, operations, and cash. As an example, we'll complete a DOG analysis of Figures 1, 2 and 3.

Debt

From the balance sheet we are able to determine two important ratios.

* The debt/equity ratio allows you to determine whether the business is overburdened with debt. In general, this ratio should be less than one. There should be a greater proportion of equity to debt in the financial structure. Exceptions to this rule do exist within certain industries. For example, most car dealerships do not purchase their new cars. Those new cars are considered debt until sold and dealerships may have very high debt/equity ratios.

* The current ratio is expressed as current assets/current liabilities. This ratio helps determine if a business can pay its current liabilities when they come due. In other words, can they pay their bills in a timely fashion? In general, this ratio should be greater than two.

In our example using Figures 1, 2 and 3, we can see from the balance sheet the debt/equity is $700,000/$300,000 or 2.33. We would expect a debt/equity of less than one. This suggests this business may be overburdened with debt in its financial structure.

The second ratio to examine is the current ratio. From the balance sheet, we can calculate the current ratio to be $970,000/$600,000 or 1.62. In general, this ratio should be greater than two. A ratio of 1.62 may suggest difficulty in covering current liabilities when they come due.

From the standpoint of debt, this business appears to have some problems.

Operations

While financial statements will not provide you with a detailed account of the operations of a business, the income statement may provide some clues. Obviously, if the business is not consistently earning a profit there may be serious operational problems. Even if the business has been profitable, it is important to determine if that profit has paralleled revenue growth. If revenue grew by 10 percent, you would expect profits to grow by the same. If they did not, find out more about the investment and expenses incurred to increase the revenue.

In our example, it is reassuring to know that this business had a positive net income of $350,000 for one year, but we cannot say much without comparing revenue, expenses and net income from previous years. In general, you should examine at least three consecutive years of financial statements to garner some clues as to the operations of the business.

Cash

Since we know cash is king, several important questions need to be asked about cash analysis.

From the balance sheet, we can ascertain how much cash is available. There must be some cash reserve available to pay the bills, including your salary. Next, we can determine if cash flow is positive or negative, as well as how cash has been obtained and used.

Another important factor is how fast new cash comes into the business. This is referred to as the days in receivables. The longer the days in receivables, the longer until the business gets its cash. The days in receivables is calculated by dividing 365 days by the ratio of revenue to the accounts receivable balance.

From the balance sheet in our example, we know the cash balance is $260,000. From the cash flow statement, we know there was a positive cash inflow of $7,000. Now, we must determine how long it takes for new cash to come in and derive whether the cash balance is adequate to cover expenses.

To figure out how long it takes for new cash to come in, we must calculate the days in receivables. We divide 365 days by the ratio of revenue, obtained from the income statement, to the accounts receivable balance, obtained from the balance sheet. From our example, we can see this equals 365/($1,500,000/$580,000) or 140 days (3.5 months). This would be considered high for most medical practices.

Cash reserve

To determine the cash reserve of the business, divide the yearly expenses obtained from the income statement by 12 to estimate monthly expenses. There should be a cash reserve equal to three to four months worth of expenses.

For example, if the average days in receivables are 90 days, and monthly expenses are $20,000 per month, then the business should have a cash reserve of at least $60,000. Obviously, the longer it takes new cash to come in, the greater the cash reserve the business requires.

In our example, must determine if the cash reserve is adequate. From the income statement, we can estimate monthly expenses by dividing yearly expenses by 12 ($1,000,000/12) = $83,333/month. We then multiply monthly expenses by the time it takes new money to come in ($83,333x3.5) to determine the required cash reserve of $291,667.

The analysis shows

Is the business in our example financially sound?

Having completed what we could of the analysis with information for only one year, there are areas of concern.

* The high debt/equity ratio

Although it is high, the business is attempting to use some of its cash to pay down its debt since the cash flow statement shows an outflow of cash of $40,000 to repay long-term debt.

* The current ratio is low

While a ratio of 1.62 is close to 2.0, it is important to realize that more than half of the current assets are in the accounts receivable balance. That means they're not readily available as cash. In addition, the days in receivables are high at 140 days. You should investigate why this is so. Is it the payer mix? Is it an operational problem?

* The net income is positive for the stated period. This is good, yet we need to see the trend over the last several years.

* Finally, although the cash reserve is close to the calculated cash needs this business must be very cautious given its high debt structure.

While financial statements give us a great deal of information about the structure of a business, they are prepared on an historical basis. They reflect what has taken place, rather than the current conditions.

Another limitation of financial statements is they reveal nothing about the value of a business. Amazon.com's financial statements, for example, would show you a business that failed to achieve a profit. Yet, it continues to have market value since investors feel the company has the potential to be profitable.

Examination of financial statements is the first step toward evaluating any business. Understanding what the three financial statements tell us and using the "DOC" analysis can give you the fundamental information you require to help you make an informed decision about a business venture.

David P. Tarantino, MD, MBA, is the executive medical director of Shock Trauma Associates, PA., a 50+ physician, multispecialty practice associated with the University of Maryland School of Medicine. In addition, he is the chief executive officer of The MD Consulting Group, LLC, a health care management consulting firm in Baltimore, Md. Tarantino can be reached by phone at 410/328-3198 or by e-mail at [e-mail].

Figure 1.
Balance Sheet
Current Assets
Cash                           $260,000
AR                             $580,000
Inventory                       $10,000
Prepaid Expense                $120,000
Total Current Assets           $970,000
Property, Plant & Equipment
Equipment, Furniture            $50,000
Depreciation                   ($20,000)
                                $30,000
Total Assets                 $1,000,000
Current Liabilities
Accounts Payable               $350,000
Accrued Expenses               $190,000
Income Tax Payable              $10,000
Short-term Notes                $50,000
Total Current Liabilities      $600,000
Long Term Notes Payable        $100,000
Stockholder's Equity
Retained Earnings              $300,000
Total Liabilities &
Equity                       $1,000,000
Figure 2.
Income Statement
Revenue               $1,500,000
Operating Expenses   ($1,000,000)
EBDIT                   $500,000
Depreciation            ($20,000)
EBIT                    $480,000
Interest                ($20,000)
EBT                     $460,000
Income Tax             ($110,000)
Net Income              $350,000
Figure 3.
Cash Flow Statement
Cash from Operating
Activities
Net Income [*]                           $350,000
Changes in Assets
and Liabilities
   Accounts Receivable     ($320,000 )
   Inventory                 ($5,000 )
   Prepaid Expense          ($10,000 )
   Accounts Payable          $20,000
   Income Tax Payable         $2,000    ($313,000 )
Operating Cash Flow                       $37,000
before Depreciation                       $20,000
Depreciation [**]
Cash Flow from Operations                 $57,000
Cash Flows from Investing
Purchase of Property,       ($10,000 )
Plant, Equipment
Cash Flows from Financing
Increase in short                 $0
term debt
Long Term Debt              ($40,000 )
Capital Stock                     $0
Dividends                         $0     ($40,000 )
Change in Cash                             $7,000
(*)Net Income is obtained
from the Income Statement
(**)Depreciation Expense is
obtained from the Balance
Sheet