Unitron Business Accelerator Series: Financial Statements in Depth - How to Read and Analyze (Part 2)

Editor's note: This is a transcript of a live seminar. To view the course recording, register here: /audiology-ceus/course/practice-management-marketing-business-issues-unitron-practice-development-series-part-18771 The transcript of Part 1 was published on 9/26/11, and you can view the transcript of Part 3 here.

Welcome to Part 2 of this three-part series related to financial statements brought to you by Unitron. My name is Jeremy Kiecker, and I am a Certified Public Accountant (CPA) with MTK Accounting Solutions out of Edina, Minnesota. The first session of this series talked more about the importance of financial statements, what to expect out of your accountants and your bookkeepers and how to better work with them. Today we will go into more depth on the financial statements. We will talk a little bit about cash versus accrual accounting, profit and loss (P&L) or income statements , key performance indicators (KPI), balance sheet review, and then key problem areas I often see in financials. In Part 3 of this series we will go into more detail talking about budgeting, cash flows, and tax considerations.

Working in Minnesota puts us in close proximity with many hearing aid manufacturer headquarters, and we have been working in the hearing industry for seven years now. We offer outsourced accounting services to people throughout the United States, where we essentially take the place of an in-house bookkeeper, or supplement the services of an internal bookkeeper. We like to pride ourselves on timely and accurate financial statements. We also help businesses implement and use Intuit QuickBooks accounting software. We also do accounting system consultations, so if you are doing the books yourself or have an accountant or bookkeeper that would like to talk to us, we can review your accounting system and give you pointers on how to improve your current processes.

Financial Statement Overview

The first thing I want to do is talk about a standard chart of accounts. Appendix A shows a standard chart of accounts that we have provided to various audiologists over the years to give them some sort of a guideline. The standard chart of accounts is the starting point of your entire accounting system and is the first thing you need to really build your financial statements. So when you start up an accounting system or QuickBooks, it will ask you for your chart of accounts, and sometimes there is a default layout already loaded, but it is not really specific to your industry. Basically, it all ends up being a bunch of buckets that you throw your revenues, expenses, assets and liabilities into, and it is all about consistency. You have to consistently throw information into those buckets from day to day, week to week and year to year so you can start to notice trends. I think most business owners are interested in breaking out revenues into the right buckets: hearing aids and related services, diagnostics, earmolds, and the cost of goods sold (COGS). I see a lot of business owners lumping a bunch of these items together. They might have one COGS bucket, or they might only have one sales account, and again, your financial statements are supposed to give you a lot of information about your business. You want to make sure you keep all of that detail sorted out, whether you have your own accounting system or you use a patient management system.

Also included on the chart of accounts is selling cost, and this is where we talk about the consultant salaries, commissions, advertising, credit card fees, et cetera. Then we get into the typical general and administrative expenses such as rent, insurance, administrative wages, taxes, and so forth. At the bottom of the form, you have Other Income where you might put interest income and expenses. This is not the end-all be-all to standard chart of accounts, but it is a guide (Appendix A). If you are looking at doing a major overhaul to your chart in your accounting software, I would recommend waiting until the end of the year and doing it fresh from the beginning of the next year.

Cash vs. Accrual

The next concept I would want to talk a little bit about is the difference between cash and accrual accounting and the impact it has on your business and the financial statements that you generate. When I start working with a business, I want to first identify what method of accounting are you using: cash or accrual? Optimally, you want to be on an accrual basis of accounting. The key difference between cash and accrual is that cash accounting only cares about the cash you actually collect and the cash you actually pay during a certain period of time. Accrual accounting is concerned with how much the entire sale was. So if you sold a $5,000 set of hearing aids and you received a $2,000 down payment on it, the cash basis of accounting would only record the $2,000. Accrual basis of accounting would record the entire $5,000, and the $3,000 that is still left over would be considered accounts receivable. You may also think about cash versus accrual as accounts receivable (AR) and accounts payable (AP). Say you owed Unitron $10,000, and you only paid $2,000. The cash basis would only pick up the $2,000 expense. Accrual basis accounting would pick up the entire $10,000 because you enter it based on invoices, and it would show up in your accounts payable in QuickBooks. So that extra $8,000 that you owed would show up as liability on your balance sheet.

You end up seeing a bit of a rollercoaster effect on the financial statements when you use cash accounting. One month you might receive an influx of cash, but you might not pay many bills. This would make you show a huge profit because you have not yet spent that money. The next month you might pay a whole bunch of bills and not collect much cash, so you show a huge loss. There are a lot of ups and a lot of downs with this. The accrual basis does a much better job of matching your revenues with your expenses. It is much more consistent. With accrual accounting, you record all the revenues when you have earned them and record all the expenses when you have incurred them, not when you have paid them. So the key difference between the two is just the matching principal: matching revenue with expenses. It is a mindset. Of course all of this happens most effectively when you actually enter all of that information into your QuickBooks. If you are using QuickBooks or another accounting software and you enter sales invoices or synchronize the sales from the patient management system, it is going to do the accounting on the accrual basis of accounting.

Some clients tell me their accountant told them to use cash accounting, but I will always clarify that statement by asking if they are using cash accounting for financial statement purposes or tax purposes. You can be using cash for tax purposes and accrual for financial statements. It is an easy transition at the end of the year. Your accountant can help you do that, but you do want to clarify how your financial statements will be run. If you want to get a good picture of how your business is performing, use the accrual basis of accounting. It is not that hard if you are already entering invoices and paying bills through an accounting system.

Income Statement Overview

When I start talking about financials, I use the terms balance sheet and income statement. Those are two basic pieces of your financial statements that you should be receiving from your bookkeeper or accountant. You should also receive the general ledger detail which breaks down all the activity on your accounts on a regular basis. I am going to start with the income statement because I think that is the most popular piece of the financial statements that people will look at. The income statement also goes by profit and loss (P&L) or statement of revenues and expenses if you are getting confused. That is warranted because it goes by many different names. The revenue, less all of your expenses, shows your income. The bottom line will show you whether or not you are at a profit or a loss. At a minimum, you should be looking at the bottom line to gauge how you are doing. Again, it is very important to make sure that you are inputting all of your information accurately and comprehensively. The income statement is also a tool that can compare the most recent month, quarter, or year. In QuickBooks you can run it by month, week, day, or by location. My favorite P&L is by location, and then I take it a little bit further and run it by month so I can look for trends and seasonality. So again, you have to be comfortable with what you are looking at and dive into the details. Income statements also help locate and diagnose problem areas regarding sales, margins and expenses, and provides a method for you to investigate these areas within a reasonable amount of time.

Let's talk about the P&L statement. Appendix B is a sample P&L sheet over a 12-month period. It breaks down the revenue categories into the proper buckets, whether you are doing hearing aids, diagnostic services, selling warranties or earmolds or things like that. Another key piece of information in the far-right column (Appendix B) is percentage of income. The percentage of income is a wonderful tool to identify where there may be percentage issues. Is your COGS percentage too high, or is your advertising percentage too high? Some reports do not show this calculation on default, but you can manually go in to your software and turn it on to show in the report. One of the first things that I look at on a P&L is the total COGS, which says 29.5% on the sample P&L sheet (Appendix B). Every business is a little bit different depending on the pricing you are getting from your manufacturer and your mark up. The hearing industry's total COGS can range from 25 to 40 percent, depending on region. Most of the time if you ask a business owner what their COGS percentage is, they will be able to tell you. If you do not know that, then you definitely have a little bit of work to do there.

The COGS is one of the key performance indicators (KPI) on a financial statement. If the percentage looks very high, over 50, or very low in the teens, I do not have a lot of confidence in those financials because I feel like something is wrong. I would probably start questioning whether or not you entered all of your bills if the percentage was too low. If it was too high, I would wonder about BTEs that were sold but were already in inventory. These are the kinds of the things that you have to look for and be comfortable with to know where to look for them on your financial statement Advertising percentages can be in the mid-teens, as a ballpark figure. Somebody with advertising percentages in the low-to-mid 20s or even 30 percent may have questionable marketing procedures. Is that advertising really paying off? That percentage can usually tell me how well your advertising has been going, and in the distressed economy I see more people inching up into the upper teens. If you are getting up into the low 20s, you are probably wasting some money and need to be adjusting accordingly.

Some people ask me how to delineate salaries, but that depends on so many factors. Are you an owner or a manager? If you are an LLC, you will not be pulling a salary out of there. Do you employ audiologists? Where in the country is your practice located? I do not get too involved in that aspect, but you can talk to other audiologists and owners in your area and find out what is trending in those areas. In Appendix B you can see how income and expenses are broken out from hearing aids, accessories, earmolds, selling costs, consultant salaries, commissions, advertising, credit card fees, and clinical supplies. Those are all the supplies that you need to do your day to day operations. It is beneficial to break out your selling costs so you can see where money is going.

I am an advocate for third-party payroll providers. I find some people who say, "I am going to do payroll manually or use QuickBooks." Then they find out there are multiple levels of payroll you can be doing through QuickBooks, and if you do not pay for all of their services you might not get to-do reminders at a certain time. Some people get themselves into trouble when it comes down to payroll, so I am usually an advocate for a third-party service that you pay to manage your payroll. They will handle direct deposit and pay your quarterly or annual fees, but then they also have a downloadable synchronizer where you can access the payroll system online and enter what you need. If you send by fax or call them over the phone there could be errors there, so I always recommend using their online payroll features. If you are worried about security measures, you can identify which employees you want to have access to different parts of the software.

This is really all about consistency and making sure all of your expenses and revenues are going into the right buckets. You must review the GL detail at the end of every month to make sure everything adds up. Are all the expenses in the right accounts? One of the biggest pet peeves I have is huge miscellaneous expense accounts. Miscellaneous items should really be pieced out and classified as specific expenses. Again, it is up to you as a business owner to make sure those expense accounts are where you want them, and if you want more detail, add more detail, but be conscious to not overdo it.

In my mind, the documents presented here (Appendix B) are very cosmetically appealing financial statements. It is one page for combined P&L and one page for P&L by location. I do not like to use a lot of subaccounts. Some people get carried away with subaccounts, and then it becomes impossible to view the financial statement that has now spread to three or four pages. Try to keep it to one page. On the P&L combined statement (Appendix B), it shows a net income of $32,838. The previous year, in the middle column, it showed a loss of $5,188, so we want to identify what the problem was in 2009. In 2010, we are making money. Why is that? The reason looks to be that revenues were up $100,000. Once you get all of the information entered appropriately, you can really start to compare trends over the two years. You can examine where you are overspending, where you are not spending enough, and then make some good management decisions based on that information.

If you look at the P&L by location (Appendix B), you can see the breakdown between Edina, Minnetonka, and Plymouth. I like to have a fourth location called "admin," which is the overhead and corporate expenses that you cannot easily divide down into a specific location. If you are getting sales invoices, it should be fairly easy to allocate those to a specific location; same for the COGS. Utilities are easy to identify, rent is easy to identify, and your salaries are easy to identify. Using a synchronizer will synchronize the payroll information to the proper location. If you are using QuickBooks, tell QuickBooks the location to which you want the person's salary to go.

You do have a few categories that are not that easy to break down. These could include the accounting fees, the office liability, or perhaps the officer's salary because the officer is helping with the entire business. Then you code those to your admin column, and at the end of the month you can do a journal entry to allocate all of those expenses across all three of your locations, which you can see has been done at the bottom of the first column on the P&L by locations sheet (Appendix B). That is why it shows a negative $72,353 under allocated expenses because $24,000 has been allocated to each of the three locations. Basically, you decided that you needed to absorb the cost of this. The allocated expenses really tell you how the organization is doing as a whole. You can talk with your accountant about setting up and arranging the categories of the P&L statement. I really do recommend having a P&L by location if you operate out of more than one location.

Looking back at the bottom line of each location (Appendix B), you can see that first location, Edina, has loss of $70,000, Minnetonka has profit of $93,000 and Plymouth has a profit of $10,000. If you have a location showing a loss of $70,000, you need to find out what the problem is. When you have a P&L by location, you can see right away that Edina did not have high sales and spent a lot on advertising. In the far-right percentages column, you will notice that the Edina office has a high advertising percentage. These P&L sheets, combined and by location, can be very valuable in diagnosing problem areas within your business.

Key Performance Indicators (KPI)

There are several KPIs that are included on your common financial statement. The first is the COGS. COGS is calculated as the cost of the hearing aid or expense divided by your total net revenues. QuickBooks does it automatically for you if you turn on that feature. Advertising is another KPI, and should again fall around 15 percent. If your advertising percentage is in the mid 20s, you are probably wasting your money. If you are in the low teens or single digits, I would question whether or not you have all of your expenses coded properly. The third KPI, returns, should fall at a rate in the low teens. If you are in the low 20s, you need to examine why people are returning so many hearing aids. The average selling price (ASP) should be common knowledge within your business. If you are using patient management system, it will calculate that for you. You should also have a good idea of the number of units sold, because the units sold is how you calculate the ASP.

Dashboards are important, and a lot more accounting platforms are giving you the option to look at dashboards. Dashboards allow you to look at a host of information easily on one page. So if you want to look at which patients owe you the most money, to which vendors you owe the most money, or how much how have in the bank account, a dashboard does a good job of organizing all of that information on there for you. A dashboard allows you to pick and choose which information you want to be included. If you need some help with that, talk to your accountant or bookkeeper. You have spent so much time getting the information into the accounting system, it would be a shame not to use it all the way the program intended.

Balance Sheet

A sample balance sheet can be found in Appendix C. The balance sheet is also one of the key pieces of the financial statement. It lists all the assets and liabilities of a business. You should typically be looking at your balance sheet on a monthly basis, at minimum. Your accountant should be able to generate the balance sheet, and everything on there should make sense. The bank balance should make sense. If it is showing up as a negative balance, then there are problems with the accounting function, or someone has not reconciled that account, or you have overdrawn your account. When I start working with a client, often the P&L looks okay, but when I get into the balance sheet, things have not been tied out since the end of the previous year. This is something that really needs to be tied out on a monthly basis because 99 percent of the time, if something is not tied down or the balance is not accurate on the balance sheet, it means your P&L or income statement is also wrong. The balance sheet will also tell you if you liquidated everything now, would you have anything left in your checking account or not. It will also tell you how much is available for upcoming commitments and how much you owe on loans and to other creditors. This is a statement that is absolutely necessary. You need to have access to the full set of financial statements to make sure that everything is accurate and that you get a good picture of how your business is performing.

If you look at the sample balance sheet (Appendix C), you will see it lists all the assets and all the liabilities and equity. Balance sheets are set up in order of liquidity, so the more-liquid assets show up on the top, and the less-liquid assets are toward the bottom. Cash is very liquid so it is listed at the top in the checking and savings accounts. You could go into the bank and liquidate those accounts easily. Next you see Inventory. You would have to sell the inventory before you had cash-in-hand, so a little less liquid there. You get the idea.

The same organization pattern goes for Liabilities, but it is ordered on when the expense becomes due. Accounts payable is typically due within the next 30 to 60 days, so it is right there at the top. Credit cards typically come due within 30 days. If you have a loan, it is due further out over a course of several months or even years.

The Equity section shows how the business has performed historically. That is one of the first things that a banker will look at. They will ask for the balance sheet. If you try to get a loan, they will ask for your balance sheet as well as your P&Ls to see how the business is performing and what equity you have in the business. Equity tells us historically how much money have you made, how much money have you kept in the business, and if the business has a history of producing profits. Sometimes you run into a business that has had a couple of bad years, and the owners have distributed almost all the money so there is a negative equity. They went further into debt to keep the business going. If a banker sees that, they are going to be nervous and wonder what the odds are of getting their loan money back.

Any asset that you have that is related to your business should be on the balance sheet. If you are buying a bunch of hearing aids and have stock sitting on your shelves, the purchase price or the cost of those, not what you are going to sell them for, should be showing up on the balance sheet. The accounts receivable should match what you have in your patient management system or the sales invoices in QuickBooks. You should be able to drill down into that and identify who owes you money. You can even run an aging report for 30, 60, 90, or 120 days to see how long that money has been unpaid. Collection procedures are imperative as you watch those accounts receivable become old, and as you work with insurance companies. Under Total Fixed Assets you will find Goodwill or Covenant Not to Compete, and these would only be recorded if you sold or purchased your business from somebody. Goodwill is basically the intangible value of your business. It is just what people in their minds think about the business.

Accounts Payable is what you owe all of your vendors and is listed first under Liabilities and Equity (Appendix C). You can, again, run an aging report to show all the vendors to whom you owe money and how old those bills are getting. If I ran an aging report and there were a lot of bills sitting in there from 90 to 120 days, this would indicate you are having problems paying your bills. Are sales down, are you spending too much money personally, are you paying yourself too much in a salary? You need to make changes there.

Credit cards balances must show on the balance sheet at the end of the month. Even if you will pay it off a few days into the next month, it still should be on here. I have run into people that have never recorded credit card balances, to the tune of almost $100,000. There is a module in QuickBooks that will let you track your credit card payments and balances.

If you have a loan with the bank, make sure it is recorded properly and it matches what the statement says. So again, the key here is to make sure that all of these numbers make sense. If they do not, ask the question. Make sure they are adjusted appropriately because that tells whether your P&L will be accurate. Look at last year versus this year. Analyzing those financial statements to look for trends is really important. The P&L or income statement ties in directly with the balance sheet, so you have to be looking at both of those very carefully on a monthly basis.

I challenge you, if you do not understand the financial statements, talk to your bookkeepers, talk to your accountants, ask for help. You are paying them money, so they should be able to explain to you what it all means and answer any question you might have. Asking questions is important for your business.

Key Problem Areas

There are some areas where I typically find some key financial statement or accounting system issues when I go in and look at a new client. The first is bank reconciliations. An unreconciled bank account indicates missing information. That is what I was talking about before where you look at the balance sheet and see negative cash. I have a hard time believing that. I would think you would be getting overdraft notices from your bank, and I do not know of too many banks that allow you to overdraft too heavily. You have got to make sure that the reconciliation is done. The first piece of reconciling is getting good set of financial statements.

The next problem area is accounts receivable. Make sure the cash collection procedures are in line or that you are at least collecting a certain amount of cash down when somebody orders a hearing aid. For accounts payable, increasing balances owed to vendors over 60 days shows signs of cash flow problems. Make sure you are paying your bills or are taking advantage of early payment discounts if that is possible. Debt is another huge problem area. Debt and interest can put a choke hold on your business. If you are going further into debt, building up credit card balances or vendor balances, or if you owe more and more money to a bank, you have got to find out what the problem is. Are your sales not where they need to be, and, in turn, do you need to start cutting expenses? Are you paying yourself too much? Identifying the problem of increasing debt is mandatory, otherwise the whole mountain will tip over on you. You cannot continuously build up debt. I think we are seeing that ubiquitously now. You need to pay that down and find out where the problem is.

The COGS percentage can also be a problem area. Looking at the COGS can indicate how much faith is placed in the overall financial statements. A low COGS percentage might indicate missing costs; a high COGS percentage would indicate low sales price. If you see a decrease in sales, you want to verify if that is an internal or external issue. Certainly the economy has been part of the problem as of late. Some of that could be the actual provider, but some of these providers are seeing a good number of patients and just not closing the sale.

The next KPI is excessive personal expenditures. Personal spending habits really can wreak havoc on a business. I have worked with many new business owners who say, "I have to make $150,000 of salary in order to keep my lights on at home, keep my kids in school, and keep my cars in the driveway." You have to be careful and make sure you have things under control on a personal level. This is usually a hard pill to swallow, but if the company is successful and you make a lot of money, treat yourself. But if things start slowing down, you have to know how to reduce your expenses on a personal level. If the spending spirals out of control, you will run out of money and lose your business eventually. Lastly is excessive distributions. Leave money in the business for future growth. I think it is very important to make sure you continue to grow that business.

Hopefully this has been beneficial. The basic concepts are to take responsibility for your financial statements and ask questions of your financial advisors, CPA, or bookkeepers and really understand what you are looking at. Our next session will cover more on budgeting, break-even tools, and some tax planning. I hope you can join me then. Thank you for attending.

APPENDIX A

Standard Chart of Accounts
Click Here to View APPENDIX A (PDF)

APPENDIX B

Profit & Loss - Combined
Profit & Loss- By Location
Click Here to View APPENDIX B (PDF)

APPENDIX C

Balance Sheet
Click Here to View APPENDIX C (PDF)