"Cracking the Code!", Deconstructing your Financial Statements, Balance Sheet Basics (EP07) - a podcast by David Darab, DDS, MS, MBA

from 2019-03-26T09:00

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“If you don’t know your numbers you don’t know your business !!” Marcus Lemonis, from the popular TV series The Profit.


Welcome, you’re here at The Beacon, so glad you found us! Prepare to have your Blind Spots Illuminated!


Hello and welcome to our series on “Cracking the Code”, or alternatively, “Deciphering Your Practice’s Financial Statements”. We will spend the next 3 Podcasts reviewing, deconstructing and dissecting the 3 financial statements you should be reviewing at least monthly; the balance sheet, the income statement (P&L) and the statement of cash flows.


If you are like most doctors, financial statements are that “Stack of Stuff” your accountant sends you every month, but you tend to ignore! You may take a peek at a few areas you understand, Income, revenue, expenses, and of course profit, it all looks ok so not wanting to throw it out you add it to the constantly growing stack of stuff you know is important and will get to one day, but that one day never seems to come!! You secretly may be intimidated by these reports, but are too busy, proud or embarrassed to ask for help understanding them. I believe this is why so many dentists simply delegate this task to their accountant/CPA. That’s a dangerous handoff. You, as the business owner, should have a basic understanding of these reports, expert knowledge is not required. Just enough knowledge so you can speak the language of business and ask questions to your accountant, CPA or financial advisors regarding what’s in these reports. In this manner, you and your team together can improve your business and financial results.


No matter where you work in your organization, you’ll do your job better if you understand basic financial concepts. You’ll be a more effective contributor to your company’s efforts to make money and grow the business. You, as the doctor, are in the very best position to understand what resources and assets must be acquired to deliver exceptional care. Ensuring an excellent financial return on those assets just makes good business sense. If you are not receiving an above market return on your business investments then it is a better idea to take that cash out as a salary and invest it differently.


I have a promise for you before we start…


I PROMISE, I will never mention debits and/or credits, no general ledger or trial balances. Those terms may conjure up fear and dread from your undergrad accounting class! The math is here is easy too; addition, subtraction and if we get fancy we might use division to calculate a ratio.


But Why again is this important?


“Accounting, accounting, accounting. Know your numbers.”

-Tilman J. Fertitta, CEO of Landry’s Inc. and host of The Billion Dollar Buyer.


Warren Buffett says, “Accounting is the language of Business.” If you can’t speak the language how do you know how your business is doing?


It appears that “knowing your numbers” is a recurring theme!


Consider the following questions…



  • Do you know the difference between profit and cash?

  • Do you have enough cash to make payroll?

  • How profitable are the services you provide?


I will address all of these. In addition, I’ll help you…



  • Make sense of the three key financial statements.

  • Gauge your company’s financial health.

  • Weigh costs and benefits before committing resources.

  • Understand why the Profit shown on your P&L never equals the cash in your bank account? The Secret Stash is that cash is hiding in your Balance Sheet.


You won’t become an expert, but you will have a better understanding of the language and financial reporting framework.


Remember, your banker and lending institutions are very interested in these financial reports along with the financial strength of your practice. If they are interested, you should be too!


Consider this also important if you are preparing for a practice transition; adding an associate or selling your practice. Strengthening your financial position can result in the best valuation for your practice, and who doesn’t want that!!


The fact is that Finance and Accounting, like other business disciplines, are as much of an art as they are a science. There are many estimates and assumptions contained within your financial statements. Accounting and finance are not reality, they are a reflection of reality. One does not always know how precisely to allocate costs, nor does one know exactly how long a piece of equipment will last, hence how rapidly to depreciate it. Is a Cost considered a Capital Expenditure, or an operating expense? This choice has an immediate effect on the bottom line and your profitability.


Before we dive in a little background is important You should appreciate how these reports are generated by your accountant. Every financial transaction in your practice, ie; purchase invoice, canceled check and bank statement is analyzed, categorized and entered into your ledger. In most practices, the common point of data entry is your PMS along with Quickbooks.


Inside of Quickbooks are numerous categories termed a “Chart of Accounts”. It is from your chart of accounts that your financial reports will be generated. It is critical that your Chart of Accounts are properly organized and categorized! The default mode in Quickbooks is rarely adequate. The old saying..Garbage in Garbage out, holds very true here! In most practices, our very first step is to reorganize and recategorize the Chart of Accounts so we can get the financial data we are looking for. Without this, your financial statements will be utterly useless to you other than for tax purposes. Please call us here at OmniStar if you have questions about this.


It is important to recognize your accountant’s perspective and responsibilities when financial statements are prepared. The financial crisis combined with the Enron and WorldCom accounting scandals ushered in a new era of rules to ensure the accuracy of financial reports, these standards are called GAAP, for Generally Accepted Accounting Principles. GAAP was designed to stop billion-dollar corporations from deceiving and defrauding investors and shareholders. Prior to GAAP, “Creative accounting” and “cooking the books” was not uncommon. The fall of Enron, WorldCom resulted from “cooked books” and caused the complete and immediate demise of one of the worlds largest accounting firms, Author Anderson, who was the auditor of these firms.


GAAP sets the accounting standards and rules for reporting financial results, very similar to our standard of care in clinical practice.


GAAP has 2 benefits;



  1. GAAP ensures consistency over time.

  2. GAAP enables comparison between practices and firms.


GAAP has rules your accountants must follow, some of these rules are:

-assets are priced at their historical cost, ie what you paid for it, not what it MAYBE worth today.

-Conservatism, accountants will only record a number they know is accurate, accountants do not estimate nor guess at costs nor values.

-Consistency. once a company has established an accounting method it must continue with that each year.


Publicly traded firms along with larger organizations are required to have their Financial Statements Audited by an independent accountant called an auditor.


For our practices, that degree of scrutiny is not required. Our accountants prepare a “Compilation of Financial Statements," the report clearly states the statements were not audited if you read the cover letter carefully.


You should also be aware of what accounting system your practice is using to assemble your financial reports. The two different accounting systems are; Accrual and Cash.


Accrual Accounting is required by GAAP thus required in publicly traded firms as well as larger firms and practices with more complex economic transactions. The object of accrual-basis accounting is to match revenue and expenses in the period that they are earned and incurred. The cash flow from these transactions occurs at a different time. This system provides more accuracy when reporting the financial position and performance of a firm.


In the Cash Basis of Accounting revenues and expenses are recognized only when “cash” is received by or paid out by the practice.

Most small to medium practices, like the ones listening here, are well served with a Modified Cash-Basis Accounting system. In this system, the only non-cash economic events recorded on the books is the purchase of equipment and the depreciation expense of that equipment.


Patient receivables would not be reported on the financial statements, since they are not cash, but would be recorded internally for collection purposes within your PMS.


A Modified Cash-Basis Accounting systems provide the necessary information to comply with the IRS and file taxes. In addition, bankers and lenders will accept these reports for loan applications.


Remember we talked about Accounting having estimates and approximations. Some of these biggest distortions can occur on the balance sheet.


So let’s dig in.



A balance sheet, also called a “statement of financial position”, represents a Scorecard of the financial health of your business at a single point in time.


The BALANCE SHEET starts with the


FUNDAMENTAL ACCOUNTING EQUATION;


ASSETS = LIABILITIES + OWNER’S EQUITY


OR


WHAT YOU OWN = WHAT YOU OWE + OWNER’S EQUITY


Consider the BALANCE SHEET like a sheet of paper divided in the middle. On the left side are Assets and on the right side are Liabilities at the top and Owner’s Equity at the bottom. The summation of the left side (Assets) must equal the summation of the right side (Liabilities + Owner’s Equity).


Thus, the Balance Sheet Balances.



Lets start with Assets


ASSETS are WHAT YOU OWN; cash, receivables, inventory, prepaid expenses, Property, Plant and Equipment, Land, and Goodwill.


ASSETS are considered CURRENT or NON-CURRENT - These are listed in decreasing order of liquidity with the most liquid “cash like” assets at the top and the least liquid like land and Goodwill at the bottom.


CURRENT ASSETS are those that will be utilized within a year.



  • cash

  • Accounts receivables remember, in a Modified Cash Basis of Accounting Receivables are not cash, so not reported on the Balance Sheet. The PMS will have these amounts and aging.

  • prepaid expenses

  • inventory


SIDE NOTE HERE: all of your inventory costs money and is created at the expense of CASH. One quick Pearl is to decrease your inventory to increase your CASH! When you look in your supply area, instead of seeing box and boxes of stuff, imaging dollar bills…it’s the same thing!!! Would you rather have your dollars, or would you prefer to give them to your suppliers? The buy 10 and get one free is a tactic used by suppliers to get you to buy more, which uses your cash. I propose you have much better uses for your cash then it sitting on your shelves! The worlds largest firms use “just in time” inventory control, so should you!


NON-CURRENT or LONG TERM ASSETS are those that will NOT be turned into cash within the next year.



  • Property, Plant and Equipment is listed at historical COST, NOT MARKET VALUE


    • Less ACCUMULATE DEPRECIATION




    • This is one section where the Art of Finance appears. For example- Increase the depreciation of an asset from 3 to 6 years results in a 50% smaller charge on the Income Statement, Less Accumulated Depreciation on the Balance Sheet, a higher figure for PPE, and thus more Assets. By the Fundamental Equation of Accounting, more assets translate into more Retained Earnings!






ANOTHER ACCOUNTING RULE:


* DEPRECIATION IS ALWAYS A NON-CASH EXPENSE!


  • Goodwill



Now to the Top Right side of the Balance Sheet, LIABILITIES


LIABILITIES are WHAT YOU OWE; accounts payable, accrued expenses, payroll, bank loans, notes and lines of credit.


These are also considered CURRENT, or NON-CURRENT


CURRENT: those payable within the next year



  • accounts payable - what you owe your vendors.

  • current portion of LT debt

  • accrued expenses- payroll and taxes - your employees don’t send you an invoice, they just expect to be paid, as does Uncle Sam with taxes.

  • deferred revenue


NON-CURRENT or LONG TERM Assets are those due in over a year.



  • loans, debt, lines of credit



And finally, the bottom right side of the Balance Sheet, OWNER’s EQUITY


OWNER’s EQUITY:




  • STOCK- monies contributed by investors or owners.




  • RETAINED EARNINGS or ACCUMULATED EARNINGS are the accumulation of PROFIT or LOSSES left in the business.



    • for our world of dental practices this is where bonuses and dividends accumulate.

    • the practice entity would not retain these profits but rather pass them onto the owners as either salary or dividends depending on the legal structure of the practice thus avoiding double taxation at both the corporate and personal levels.




SIDE NOTE HERE: Consider profitability like your “Grade” in a course, you work hard in a class over a time period, a semester, and at the end of the semester you get a grade. Equity is more like your “GPA”, it reflects your cumulative performance, but only at one point in time.



So, that’s the Anatomy of a Balance Sheet dissected section by section.


How does it work?? Why is it important??


Well as the name implies: THE BALANCE SHEET MUST BALANCE


FIRST…..A BALANCE SHEET RULE:


AT LEAST 2 THINGS MUST CHANGE ON A BALANCE SHEET…This is called Double Entry Accounting!


Let’s try some transactions and see how this works and how easy it is! By doing these exercises you will begin to think and talk the language of business and finance and understand the “double edge” sword to each and every financial transaction!


Our goal in any business is to GROW your EQUITY or RETAINED EARNINGS




  1. We purchase a new Digital Pano at $30,000 with bank financing.

    So, we add an asset on the left side of +$30,000, so something must change on the right side, either a liability or Owner’s Equity. In this case, we add +30,000 of liability, the bank loan, and the Balance Sheet Balances.




  2. Say we paid $5000 of cash and financed $25,000.

    The asset still goes up to $30,000, asset cash goes down $5000 and the liability is now only $25,000

    Tada…the balance sheet balances yet again.




You all Getting it??!!




  1. Let’s Buy $4000 supplies with cash.

    An asset, Supplies goes up by $4000 and another asset, Cash goes down by $4000…the Balance Sheet Balances. No change in Liability or Equity




  2. How about Buy $4000 supplies with credit.

    An asset, supplies, goes up by $4000 and a liability, accounts payable, goes up by $4000…the Balance Sheet Balances.




You will learn when we review the Income Statement, or P&L, that your profitability or “Bottom Line” is connected to the Balance sheet through the Owner’s Equity Section.


All profitability increases owners equity.


That’s really important so let’s say it again…

ALL PROFITABILITY INCREASES the OWNERS EQUITY portion of the balance sheet!!!


This concept is critical and links your Income Statement / P&L to your Balance Sheet!


So as we just learned 2 things, at least, must change on a balance sheet if Owner’s Equity Increases. Either an asset increases or a liability decreases, or a combination of those.


Herein lies the answer to the nagging issue of why my practice is profitable but lacks cash! Look closely at all of your asset categories, your cash may have disappeared there; buying supplies, equipment or technology, or paying down liabilities, bank loans, and debt.


This works in reverse too…accelerate the depreciation of your equipment (ie section 179) which reduces the VALUE of that ASSET,

and correspondingly reduces your Owners Equity side of the balance sheet too.


Finally, the “profit” you have achieved is equity and not cash, remember that…Profit does not equal cash! We will talk about that when we dissect the Income Statement.


SUMMARY:



  • reviewed basic accounting principles

  • GAAP

  • Accrual vs Cash Basis of Accounting

  • Fundamental Accounting Equation, ASSETS = LIABILITIES + OWNER’s EQUITY

  • 2 Things on the Balance Sheet must change with every transaction

  • Income Statement and Balance Sheet are connected through the OWNERs EQUITY Portion.


So that wraps things up for this Podcast.  Hopefully, you have a better understanding of the mechanics of the balance sheet. We hope that this information has created a few “Ah Ha” moments, or stimulated some additional questions you can direct to your advisers.  We welcome your inquiry here too at OmniStar Financial.  Our contact information can be found on our website OmniStarfinancial.com.  You will also find a link to sign up for our newsletter.  Please share this podcast if you found it helpful, and leave a review on iTunes too.  We welcome your feedback and suggestions for future podcast sessions.  You can always find me, your host, David Darab, at my twitter handle, @ddarab.


Thank you so very much for tuning in and listening.  We are very grateful for your time and attention and so very pleased to have you in our audience.


REFERENCES:


https://www.amazon.com/Financial-Intelligence-Revised-Managers-Knowing/dp/1422144119/ref=sr_1_4?keywords=financial+statements&qid=1553527149&s=gateway&sr=8-4


https://www.amazon.com/gp/product/0648424006/ref=ppx_yo_dt_b_asin_title_o03_s00?ie=UTF8&psc=1

Further episodes of The Beacon-Podcasting for Dentists

Further podcasts by David Darab, DDS, MS, MBA

Website of David Darab, DDS, MS, MBA