Enterprise Finance
Prepared for the American Academy of Orthopaedic Surgeons
“Business, Policy, and Practice Management in Orthopaedics” Lecture Series
By Shyam K. Vekaria, MD and Bonnie S. Mason, MD
Objectives:
1. Understand basic accounting and finance terminology.
2. Understand the “time value of money.”
3. Introduce types of financial statements and how different aspects of the
statement can be derived.
Table of Contents:
1. Basic Accounting Terms
2. Basic Finance, including Time Value of Money
3. Financial Statements
Key Takeaways:
1. Understand the broad categories of Revenue, Expenses, Assets, and Liabilities,
and how Net Income and Net Worth are calculated from these entities
2. Understand differences between Fixed and Variable expenses. Fixed
expenses do not depend on the volume of services rendered, whereas
variable expenses do.
3. Money has “time value” due to utility, interest, and inflation. A sum of money
today is therefore worth more today, than the same sum of money at some
point in the future.
4. Learn how to calculate Present and Future values, using the formula:
FV = PV (1+ i)n.
5. Appreciate that this information represents only an introductory review of
the fundamentals of finance and accounting. Understanding these basics and
working in conjunction with a practice business manager may help keep
physicians engaged, enhance profitability, and/or limit fraud and
embezzlement.
Chapter 1: Basic Accounting Terms
Medical professionals may become overwhelmed when presented with an
opportunity to evaluate financial statements. They may even find it difficult to
remain engaged in day-to-day business operations of a practice. While there are
typically dedicated business managers in a practice setting, having a rudimentary
understanding of different aspects of your practice as a physician can be an
invaluable tool.
In fact, having a basic understanding of financial terms is recommended for
physicians who would like to contribute to the medical practice’s decisions. Routine
participation in a practice’s financial meetings can breed a higher level of
understanding for the physician, can contribute to the practice’s overall profitability
and can help to minimize embezzlement and fraud within a practice.
Here are the basics:
Financial statements are typically prepared in one of two ways, the Accrual Method
and Cash-basis Method. Each of these methods utilizes the same basic components,
which are defined below. Many larger practices may use the Accrual Method, where
revenue is considered earned and expenses incurred at the time of healthcare
delivery. The actual income may arrive at a later date. This is opposed to the CashBasis Method, where revenue is accounted for after it is received, and expenses after
they are paid. There are advantages and disadvantages to each of these
preparations, and the assistance of a professional accountant may be helpful to
understand the differences between the two.
Revenue (Income): What your practice earns from office visits, in-office diagnostics,
surgeries, etc.
Expenses: What your practice spends (includes overhead, employees’ salaries and
wages).
Expenses can also be subdivided into:
1. Fixed Expenses refer to all expenses which exist irrespective of patient
volume and can include rent, utilities, taxes, insurance premiums, and certain
employee salaries (if under contract).
2. Variable Expenses refer to expenses which result from healthcare delivery,
and can include medical supplies such as cast padding, billing, office
paperwork etc. It is related to the volume of services rendered and
resources used. Employee wages may also considered variable expenses in
some circumstances (if hourly wages)
Net Income (Net Revenue, or Cash Flow) = Total Revenue – Total Expenses
Assets: Includes all tangible and intangible items of value that the practice owns,
including equipment (at depreciated value), cash, property and other real estate,
furniture, as well as other non-physical assets such as stocks, bonds, and other
business interests (surgery center, therapy center etc.). Depreciation can be
calculated in different ways and is addressed later in this chapter.
Liabilities: Amounts that are owed, including mortgages on properties, long and
short term debt.
Net Worth (Equity) = Assets – Liabilities
These basic accounting terms and definitions as described above, and their
relationships to each other, will appear on various types of financial statements. It is
important to have a generalized notion of what each category contains, but realize
that they can quickly become much more complex and may require assistance from
a professional accountant.
Chapter 2: Basic Finance and the Time Value of Money
Money has time value, meaning that a dollar today is worth more than a dollar in the
future, whether it’s a day, week, or many years from now. One reason is that you
can take your dollar today and use it to purchase something now, getting immediate
utility of the dollar (as opposed to having to wait). One might invest the dollar today
to obtain the original investment plus an additional sum of money at a later date, in
compensation for the delayed personal utility for that dollar, and for taking a risk
that all or part of the dollar may be lost. The additional sum of money for time (the
delayed utility) and risk is called Interest.
Interest is a time-based fee or price paid for the ability to use money now.
This can be represented formulaically as:
FV = PV (1+ i)n
Present Value (PV) = How much money you have right now
Future Value (FV) = How much your money might be worth in the future
Interest (i) = price per period for use of the money
n = number of compounding periods (could be daily, monthly, quarterly, etc.)
For example:
How much would $100 be worth 2 years from now, with an interest rate of 10%
compounded annually?
Present=
Year 1=
Year 2=
$100
$100 (1+0.10)1 = $110
$110 (1+0.10)1 = $121
The formula above can be used to calculate the future value of any monetary
amount in the present. By simply rearranging the same formula (see below),
PV = FV / (1+i)n
One can take a future cash payment or asset value and convert it to a present value
to help you make a decision today. When calculating the present value, the future
value must be discounted, indicated by a discount rate (i).
For example, if a practice was looking to acquire an ancillary service or enterprise
(e.g. a surgery center), a practice may be able to look at revenues (or cash flows)
annually for the next several years, and after discounting these appropriately using
the simplified formula above, have a ballpark idea of the present-day “value” of that
acquisition. There are, of course, many other factors that play a role in such a
purchase, but simple math allows one to estimate present and future cash values,
and evaluate them side-by-side in the present or in the future.
For the purposes of this chapter, we can gain an understanding of present and
future value using simple math and a series of assumptions. In real-life, however,
the interest or discount rate may be variable depending on the time period, and
there is a component of risk that must be factored in. Accurately assessing the
interest or discount rate is much more difficult and is well beyond the scope of this
chapter. However, a working knowledge of this concept can inform your
understanding of and participation in your practice’s (or department’s) business
meetings, making you a more active participant.
Another reason that a dollar is worth more today than in the future is Inflation.
Inflation is typically described as the relative increase in prices for goods and
services over time, making your dollar less valuable in the future. Monetary
Inflation, which refers to the decrease in the value of a currency over time, is usually
due to increases in the money supply itself and may contribute to the general
“inflation,” as people have more currency to use to compete for buying goods and
services.
Chapter 3: Financial Statements
Financial Statements are used by owners and managers of a practice to help manage
the practice. Financial Statements might also be used by outside physicians,
landlords, and lenders/bankers to make informed decisions to join a practice, lease
office space to the practice, and lend money to the practice respectively.
The three most commonly prepared financial statements are:
1. Cash Flow Statements
2. Income Statements
3. Balance Sheets
A Cash Flow Statement provides a summary, over a set period of time, for the cash
that flows through a practice. It includes cash that flows in as a result of all revenuegenerating services, and the total amount of cash that flows out of the practice, due
to its fixed and variable expenses. This gives a comprehensive look at the practice’s
finances.
An Income Statement, which can also be known as a Profit and Loss Statement,
provides information of cash flow (including revenues and expenses) for a given
period of time. These can be prepared annually, or more frequently (i.e., monthly).
Deducting expenses from revenue leaves the final net profit or loss for a given
period of time.
The Cash Flow Statement and Income Statement are similar in many respects in that
they each illustrate a practice’s performance over a set period of time. There are
some non-cash accounting elements that are present on the Income Statement, such
as depreciation, which are not included on a Cash Flow Statement. The Cash Flow
Statement delineates the amount of money that flows into and out of a practice, and
exactly how it is being spent. It is a critical piece of information to help create a
more complete picture of a practice’s “true” profit.
A Balance Sheet, unlike the Cash Flow Statement or Income Statement, is a snapshot
of the practice at a point in time, and is therefore constantly changing. It should
include Assets, which are broken down into broad categories (not specific individual
assets). Next, it should list the Liabilities, with broad categories for debts owed. The
last section would be Equity, which is Assets – Liabilities, and what may be
considered the Net Worth or Booking Value of the practice. As its name suggests, this
statement is always balanced, and Assets = Liabilities + Equity (this relationship is
mentioned above, however the formula has been rearranged).
To compare these financial statements to examples in medicine, consider the fourthyear medical student who is applying for a residency position. This student is
evaluated based on the following three components of the application process:
1) ERAS Application
2) Sub-internship
3) Interview
The ERAS application gives the residency program a comprehensive view of the
student’s academic achievements, character and experiences. This may be
analogous to a Cash Flow Statement. The sub-internship provides the program
interaction with this student over an interval or period of time, usually 30 days,
and would be analogous to an Income Statement. Finally, the student ‘s interview
with the residency program provides a snapshot of the student’s abilities and
presentation. Residency programs use this multi-dimensional approach to assessing
a student for a residency position to create an assessment that is as comprehensive
as possible.
Likewise, the aforementioned financial reports are created to assess the financial
state of an entity. Each report taken separately provides specific financial
information about the entity, in this case a medical practice. Yet, the set of financial
reports together provide a comprehensive look at the practice’s financial state.
The different types of information presented on these financial statements are
important for the physician administrator of a practice or other medical enterprise
to understand, as these financials should be reviewed routinely in order to assess
the practice’s performance and viability.
A practice accountant may also develop a Depreciation Worksheet, which
summarizes the various hard assets owned by a practice, such as equipment or
furnishings, and the “wear and tear” that is expected over a given period of time.
The length of time over which an item is “depreciated” is regulated. The
depreciation may be calculated as Straight Line (steady linear depreciation over the
expected life of an object), or Declining Balance (accelerated depreciation during
early years, slower in later years). Depreciated value can be significantly different
from Replacement value, depending how it is calculated. This can have significant
implications for the practice, e.g. in determining tax write offs or liability. This can
be an important item to discuss with an accountant.
Sample Income Statement
AAOS ORTHOPEDIC SPECIALISTS
Income Statement
Year Ending December 31, 2013
REVENUE
Professional Fees
Product Sales
Ancillary Income
$4,575,000
$550,000
$125,000
NET REVENUE
$5,250,000
OPERATING EXPENSES
Provider Compensation
Provider Benefits
Staff Compensation
Staff Benefits
Rents and Leases
Office Supplies
Telephones
Automobiles
$2,050,000
$50,000
$1,450,000
$45,000
$415,000
$7,500
$5,000
$30,000
Malpractice Insurance
Travel/Entertainment
Utilities
Continued MD Education
Advertising
Interest
Depreciation
TOTAL OPERATING EXPENSES
NET INCOME
(Net Revenue - Total Expenses)
$135,000
$15,000
$65,000
$4,500
$25,000
$28,000
$450,000
$4,775,000
$475,000
As discussed, the Net Income is Net Revenue – Total Expenses. There may be small
differences in how statements are generated between different practices. For
example, a practice may leave “Provider Compensation” out of the Operating
Expenses category, and instead calculate compensation based on the Net Income.
Sample Balance Sheet Statement
AAOS ORTHOPEDIC SPECIALISTS
Balance Sheet
Fiscal Year Ending December 31, 2013
(Cash-Basis, for simplicity)
ASSETS
Current Assets
Cash
Deposits
Property
Office Equipment
Medical Equipment
Accumulated
Depreciation
TOTAL ASSETS
LIABILITIES
$200,000
$25,000
$1,500,000
$200,000
$1,750,000
($450,000)*
$1,725,000
Current Liabilities
Accounts Payable
Expenses Accrued
Short Term Debt
Long Term Debt
$1,450,000
$150,000
$50,000
$150,000
$1,100,000
TOTAL LIABILITIES
$1,450,000
EQUITY
Owner's Equity
Retained Earnings
$75,000
$200,000
TOTAL EQUITY
$275,000
*Numbers in parentheses represent a negative number for a category
A quick analysis of the Balance Sheet above illustrates the three main pieces of
information, namely Assets, Liabilities, and Equity, each broken down into broad
subcategories. As previously mentioned, the Total Assets ($1,725,000) are equal to
the combined Liabilities and Equity ($1,450,000 + $275,000).
By extrapolating the information presented in these financial statements, plenty of
other parameters and ratios, such as Overhead Ratio and Collections Ratio, can be
calculated and used to assess the health of a practice. Many of these are beyond the
scope of this primer, however, they should be available to you upon request in your
practice setting.
As a young physician starting a career, or as an established physician transitioning
jobs or looking to improve his or her practice, it is important to have a basic
understanding of accounting terms and principles, and how to analyze financial
reports. These tools may allow a provider to identify a healthy, successful practice,
or areas within an established practice that could be improved upon.
Works Cited
1. "Accounting and Financial Statements." Khan Academy. Web. 13 Oct. 2014.
<https://www.khanacademy.org/economics-finance-domain/corefinance/accounting-and-financial-stateme>.
2. Fields, Edward. The Essentials of Finance and Accounting for Nonfinancial
Managers. New York: AMACOM, 2002. Print.
3. Tracy, John A. Accounting for Dummies. 5th ed. For Dummies, 2013. Print.
4. Zelman, William N., Michael J. McCue, and Noah D. Glick. Financial
Management of Health Care Organizations an Introduction to Fundamental
Tools, Concepts, and Applications. San Francisco: Jossey-Bass, 2009. Print.