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Issue: 70 - Oct 15, 2014
Understanding Financial Statements
By: Marsha L. Heinke, CPA
Marsha L. Heinke, CPA, Inc

Raise your hand if you got into veterinary medicine to better understand financial statements. Don’t worry; I didn’t expect you to raise your hand! That said, to stay profitable and provide quality care to pets a practice manager must regularly read financial statements. Knowing how to interpret them, helps you understand ability to meet debt obligations, make payroll, pay for drugs and supplies, and maintain the facility.

To begin, a practice’s chart of accounts is the foundation of its accounting system. This list of accounts allows for the methodic collection, recording, sorting, and summarization of financial transactions. Consistently recording transactions in the same manner to the correct account listed in the chart, allows management to make apples to apples comparisons when analyzing financial data over time. Accurate bookkeeping helps determine if the practice is on pace to meet expectations.

The components of the chart of accounts can be broken down in to five categories or types of accounts: assets, liabilities, equity, revenues, and expenses. Assets can be described as “we own it”, while liabilities are “we owe it”.

Assets are acquired by using up resources like cash. Cash comes from prior practice profits or from capital contributed by owners. When the practice uses creditors to get cash or assets, it has liabilities owed to these outside parties.

Equity is often referred to as “net worth”, but this is not the same as “value” from a practice appraisal perspective. Equity represents the sum total of owner capital contributions and net profit from past fiscal periods, less anything you take out of the business (distributions).

Now that you know a few basics about assets, liabilities and equity, what are the reports to help you measure your practice? There are three primary financial statements: the balance sheet, the profit and loss report, and statement of cash flows.

The balance sheet reports assets (what the practice owns), liabilities (what the practice owes), and equity (what is left). It summarizes the accounting equation at a given point in time (assets = liabilities + equity). All assets are acquired in one of two ways: borrow money or get it from owners in the form of contributions or cumulative profits. The balance  sheet  is  often  used  by  bankers  and  creditors  to  help  determine  loan qualification.

The profit and loss statement is what summarizes revenues and expenses for a given period of time. These accounts close at the end of each year. If revenues exceed expenses, profit results, and the practice’s equity increases. Conversely, if expenses exceed revenues, a loss causes the practice’s equity to decrease. Revenue and expense accounts start fresh with zero balances at the beginning of the tax year. The profit and loss statements helps show a practice’s ability to generate profit by increasing revenues and decreasing costs required to make revenues happen.

The statement of cash flows recaps cash inflows and cash outflows from all sources. Since net profit does not equal cash flow, this statement helps clarify sources of cash and uses of cash, resulting in net increase or decrease to the checking and other cash accounts.

The key difference is that not all expenses a practice incurs are cash expenses. For example, when you purchase ImproMed Infinity practice management software it goes on the books as an asset. However, based on tax planning strategies and federal laws you may not fully depreciate the asset in a given tax year.

Assuming you didn’t borrow money to make the purchase, it has a negative effect on cash flow as a capital outlay. Conversely, the depreciation your practice takes on the software does not involve any money being spent; therefore, it’s an expense that doesn’t decrease cash flow.

The statement of cash flows has three sections. First, operating activities encapsulate the conversion of the profit and loss statement information to pure cash accounting. Non-cash deductions like depreciation are eliminated. Next, investing activities recap the purchase and sale of long term investments and fixed assets. Last, financing activities include loans or leases payable taken on in a given year as well as distributions made or additional capital contributed by owners.

More so than the profit and loss statement, the statement of cash flows shows a sharper picture of a practices ability to pay bills and loans, as well as finance additional growth.

Now that we’ve established the need for a sound chart of accounts and have a better understanding of financial statements, let’s put this information to use. Using your profit and loss statement, you can look for trends in your expense spending. Increases in expenses in a given account should trigger further investigation from management. Why did they go up? Can you identify the reasons and were the underlying causes related to purposeful management decisions for practice growth?

Common sized analysis is an approach where practices look at expenses as a percentage of revenues. Revenues drive all aspects of a practice. Simply looking at nominal expense figures can be misleading when comparing period over period. As a result, it’s better to look at profit and loss statements showing expenses as a percentage of revenues when attempting to benchmark and identify trends.

Furthermore,  timing  differences  of  payments  can  cause  large  swings  in  different expense accounts. If a practice makes a large payment in a given month to a vendor, expenses could look high for that period. This is where it can be beneficial to compare periods month by month while including 12 month rolling totals to eliminate timing differences and seasonal fluctuations.

There is a lot to reading and using financial statements. This primer will get you started, but we strongly recommend a deeper dive, such as with short course at your local community college or even on line.  Even though understanding financial statements is likely the last reason you got into veterinary medicine, it is a crucial part of the well- being of your practice.

Marsha L. Heinke, CPA, Inc.

934 Main Street

Grafton, Ohio  44044

Phone: (440) 926-3800

Fax: (440) 926-3801