Physicians grasp accounting concepts very easily. It is just a matter of learning the lexicon and transferring the concepts we already know to another context.
Accounting terminology can seem foreign at first, but didn’t you feel the same way about medical terminology at first as well? Accounting terms are actually very simple. We say scotoma to depict a blind spot. Accountants use terms such as “leverage” to describe debt. The terms may seem technical, but the concepts upon which accounting principles are based are straightforward.
Accounting reports always follow a predefined format and contain similar information. There are just four basic accounting reports, and all businesses use them. As such, accounting is far simpler than medicine. No physician should be intimidated by accounting. Every physician should understand accounting basics, terminology and how to interpret the four statements.
The purpose of this article is to demystify some basic accounting concepts in the context of a key financial report called the profit and loss (P&L) statement. While this article is not a substitute for business school or comprehensive program (such as PHYSICIAN CEO*) it will familiarize you with this vital key report that accountants use to understand a business.
A ROSE BY ANY OTHER NAME
Even though accountants all faithfully ascribe to the four statements to record a business’ health, they often use inconsistent terminology to describe them. The P&L is but one example. The P&L is also known as the income statement, the statement of profit and loss, the statement of operations, the statement of financial results and the income and expense statement. All these documents refer to the same report.
Regardless of the working title, the P&L provides one angle of a business’ financial situation. But with the other three accounting reports, a truer dimension unfolds:
- The balance sheet provides a snapshot — at one point in time — of the financial state of a business. In simple terms, a balance sheet lists what a business possesses (assets) and what it owes (liabilities). The difference between what a business possesses and what it owes determines what it is worth. So, assets – liabilities = net worth (shareholders’ equity). Therefore, in every well-made balance sheet, the equation assets – liabilities = shareholders’ equity (sometimes reordered to read assets = liabilities + shareholders’ equity) is always true. The balance sheet equation always balances assets, debt (liability) and net worth (equity). Very simple.
- The P&L is the second standard accounting report. This statement summarizes business activities over a period of time. Common reporting periods include a month, quarter or year. Simply put, P&L statements show how much value was produced (revenues), how much was committed to being spent (expenses) and the difference (profit or loss). The P&L does not report how much cash came in and went out, but the value that was produced during the reporting period. This is an important distinction that is explained further below.
- The cash flow statement reports on the actual cash that flowed into and out of the business, again over a period of time. Like the P&L, the Cash Flow statement reports cash flows over a period of time. The term “cash” in this context includes cash and cash equivalents: actual cash, plus checks, credit card transactions, bank accounts, certificates of deposit (CDs) and so on. Cash flow shows the starting figure, what came in, what went out and how much cash remained at the end.
- The statement of shareholder’s equity is the last report. It describes the outstanding shares of stock, classes of stock, options that people have to buy stock at certain prices, warrants and the changes that occurred in these instruments over the reporting period. This report is often de-emphasized in accounting discussions, but it can become critical at certain times, such as when profits are distributed, when insiders are unloading or buying stock and when the business merges with another business or is sold.
THE 10,000-FOOT VIEW OF THE P&L
The P&L reports on revenues, expenses and income in an orderly, logical format.
- Revenues report the money expected to be received based on the activities of the practice and whether the money has been paid. Revenues show at the top of the report, which is why they are often referred to as the “top line” of the P&L.
- Expenses are often broken down into operating expenses and sales, general and administrative (SGA) expenses. Operating expenses describe cost of goods sold (COGS) and include the variable costs incurred by offering the services. If no services or procedures were performed, this sum would be zero, hence the term “variable costs” as they vary according to activity. In contrast, SGA expenses can be thought of as “overhead” or “fixed expenses” as they are incurred regardless of business activities. Separating variable and fixed expenses can be helpful when analyzing a business’ health and its vulnerabilities.
- Earnings before income taxes (EBIT) show the difference between revenues and expenses. EBIT describes the profits (income) generated before taxes are paid. EBIT is sometimes reported as EBITDA, or earnings before income taxes, depreciation and amortization, in businesses that depreciate items, such as equipment, or that amortize intangible assets, such as trademarks.
- Net income is synonymous with net profits — yet another example of accounting synonyms. Net income is what the company has earned after all expenses have been paid, including taxes. Net income appears on the last line of a P&L and is the origin of the term “bottom line” that is often used to describe the firm’s overall financial performance.
Cash vs. accrual accounting
The reason why a cash flow statement differs from a P&L is a fundamental accounting concept.
Numbers are reported on the P&L when the sale is made or the expense is committed. Bills may still be outstanding, but the P&L records the activity when there is reasonable assurance that the bill will be paid. Tracking when value is created and when expenses are incurred (not paid!) is the basis of accrual accounting.
The statement of cash flow reports on cash going in and out — the cash shows up when checks are written and money is received. Monies outstanding do not show on the P&L but on the balance sheet, where they are entered as accounts payable (the business bought something but has yet to pay the bill) and accounts receivable (a sale was made but payment has not yet been received).
Accrual accounting avoids confusing cash flow with business activity. While some small businesses may use cash-based accounting for tax purposes, every business owner and manager should track business performance based on accrual accounting reports.
Because modern bookkeeping is done using software that can generate reports in both systems from the same input data, there is no reason not to have your accounting reports in both formats. This is not keeping “two sets of books” — it is reporting honest activity for different purposes: tax purposes and good management.
UNDERSTANDING THE P&L — LINE BY LINE
With this information in mind, reading a P&L becomes straightforward.
P&Ls generally take the format as shown in Figure 1. This P&L reports the business activity for a fictitious ophthalmic practice called “Great Vision” that does eye exams, has an optical shop and offers LASIK. The report covers the fourth quarter (Q4) of 2017 and compares it to Q4 of 2016.
- Operating revenues are shown in the top section. They are broken down by the revenue sources. Some businesses might have other revenues (for example, loan interest or rent income). If so, they may be reported at the top of the P&L in a separate subsection under Revenues, or in the section described below called Other income (expenses).
- Operating expense reports detail the costs of doing business. They also are shown by activity.
- SGA expenses describe the practice’s overhead. Note that physician salaries are included here. Some practices do not report physician salaries if the physicians are owners who capture the practice’s net income. Not reporting these salaries obscures true operating costs and is discouraged. Note: If the physicians performing the LASIK procedures are contractors who are only paid if procedures are done, then this cost item might be moved into the COGS section.
- Other income (expenses) reports activities outside of operations. Loan interest is reported here but not loan principal payments. The parentheses indicate negative (outflow) values.
- EBIT is the difference between all revenues and expenses before taxes are paid, as described above.
- Net income is what remains after all expenses are accounted for and the anticipated tax burden is subtracted. Even though the taxes may not be paid until the end of the year, accounting for them in each interval allows the business owner to determine the true profitability of the reporting period.
INTERPRETING THE P&L STATEMENT
P&Ls are difficult to interpret at face value. It is when we compare P&Ls over time that we gain an understanding of business growth. Comparing ratios in the P&L provides further insights as to performance and efficiencies.
Margins are the ratios that reflect efficiency. The gross margin is the ratio of what it costs to make the goods or services divided by the revenues. To use a simple example, if a practice sold contact lenses that cost the practice $10,000 for a total of $25,000 in a quarterly reporting period, the gross margin for its contact lens sales would be ($25,000 - $10,000) / $25,000, or 60%. The gross margin for Great Vision in Q4-2017 for all activities — LASIK procedures, eye exams and the optical shop — was 83.3%, up from 82.5% in Q4-2016. The trend is positive — it is costing Great Vision less to provide services, overall.
The net margin is the ratio of income (revenues minus all expenses, including taxes to be paid) to revenues. The net margin for Great Vision is 12.4% in Q4-2017, up from 6.9% in Q4-2016. Not only did Great Vision make more dollars in Q4-2017, they did so more efficiently because its net margin improved.
Note the other ratios on the right side of the P&L. The gross and net margins are universally considered, and many other ratios are useful depending on the business.
You should require key ratios to be included on your P&Ls. Some expense reports are in graphical form (Figure 2). Comparing these ratios across reporting periods, e.g., Q4-2017 vs. Q4-2016 can provide important insights about how the practice is trending.
Accountants use four financial statements because each one describes different aspects of the business. To continue the medical metaphor, this is similar to physicians considering physical findings, labs, imaging diagnostics and the patient history before assessing the patient’s condition. A P&L statement provides valuable information about a business over a given interval, but the state of the business’ health cannot be completely interpreted without the other three. Considering any of the four statements in isolation provides an incomplete picture and should be done with extreme caution.
Every physician can understand accounting, and every physician should also have a firm grasp on business concepts. I find that most physicians have a natural instinct for accounting once the terminology and concepts are explained. Most practices have physicians as their CEO, and every CEO must understand business. Accounting is just one element of business knowledge — so are strategy, marketing, operations, negotiations, finance and leadership.
Physicians make great business people. They simply need to hone the skills — and learn a new language. OM