The Importance of Financial Statements in Clinical Practice

Abstract

Background:

Financial statements provide vital information to department chiefs and hospital leadership alike. They reflect departmental performance and guide critical financial decisions for their teams. However, financial statements can be inherently difficult to read and interpret and require time and attention, understandably challenging for busy clinicians.

Methods:

Here, we aimed to demystify the several types of financial statements, including profit and loss statements, balance sheets, and cash flow statements, and explain what they reveal (and ignore). We describe key performance indicators based on these statements that are routinely used by hospital administrations. This work targets clinicians, team leaders, academic faculty, and administrators alike, recognizing that all of them share the same goals.

Results:

Mastering the basics of financial statements and using the information within them creates a healthier clinical practice. In turn, it enhances provider satisfaction and enables the team to deliver patient care without financial anxiety.

Conclusions:

Understanding financial statements helps shared decision-making between clinicians and their administrators—strengthening partnerships that synergistically drive revenue, profitability, and growth.

Takeaways

Question: What are financial statements (FSs), and how can they be used?

Findings: Net results of a strong FS:

• A. Improves confidence of employees, patients, hospital administration, other clinical departments;

• B. Facilitates retention and recruitment;

• C. Creates service stability;

• D. Increases investor confidence from the hospital administration.

Meaning: Clinicians must learn the basics of FSs and what they convey. This ensures a healthy clinical practice that can grow, thrive and be profitable.

INTRODUCTION

Clinical departments need to be financially strong and profitable.¹ Hospital leaders want a positive bottom line, as do faculty and staff. Both recognize that financial strength (or weakness) affects future investments, bonuses, recruitment, and retention. In many instances departmental financial data, the monthly performance-tracking financial statements (FSs), tend to be underutilized in guiding business decisions on staffing, productivity, revenue generation and growth.² Used properly, FSs enable both physician-leaders and their administrative partners to deliver their combined vision, underscoring their department’s alignment with hospital leadership.

Simply, FSs are records that define the activities of the department and its financial performance. Data on sources of revenue and expenses are gathered and provided monthly. At the financial year end, the FS allows one to estimate the practice’s viability.

Typical courses on FSs begin with accounting theory: dull, sometimes confusing definitions of accounts, assets, and principles of accounting, and then become more complex with FSs. This approach is not clinically oriented and alienates even the most ardent clinician-learners.

Here we propose a different, practical, approach: starting with how clinical services are structured, how they function, and what elements in their workflow translate into numbers that populate FSs. This method provides a “clinician-friendly” context to financial data, creating a connection between clinical productivity and profit.

TRANSLATING CLINICAL FUNCTIONS INTO NUMBERS IN THE FINANCIAL STATEMENTS

• 1.Identify the main services within your department.

• Most clinicians breakdown plastic surgery services into clinical divisions (trauma, cancer-reconstruction, cosmetic, hand etc.).

• 2.List all the essential elements (expenses) needed to run each service for 1 year.

• Include number of faculty, nursing and administrative staff, support services and supplies, recognizing that some elements are unique, whereas others are shared by all divisions.

  • a.Determine what each element costs (this is easy to obtain from previous data). Costs unique to a particular division are easy to assign, whereas common costs are apportioned based on percentage used by each division.
  • b.Create a table of how much it costs to run each division and what the aggregate costs are for the entire team.
• 3.Repeat step 2, except instead of costs, define the actual dollar amounts (revenue) each division brings.

Include professional fees, facility fees (if you have an office-surgery suite), lease-outs of laser equipment, rents collected, and if applicable, grants and philanthropic money raised.

Using the steps listed above, the first of the three major FSs is created: the profit and loss (P&L) statement, aka income statement (Fig. 1).³ This lists the revenues and expenses of a department in a defined period (usually the financial year). Income minus expenses determines profit aka net income.

Fig. 1.

ABC Plastic Surgery LLC P&L statement (aka income statement).

The P&L statement is typically the first document that reviewers look at. It tells them historically where the department was financially and where it could potentially go. P&L statements provide the basis for relevant clinical questions pertaining to revenue and expenses:

Questions related to revenue:

• Is total revenue adequate?

• What will increase revenue?

• Are some divisions less positive due to patient volume, case mix, or payor mix?

• Do patient volumes need to increase?

• Will the providers be able to absorb the increase?

• Are services underpaid, and if so, should contract negotiations be reviewed?

On the expenses side, the income statement reveals clinical opportunities for cost-containment.

• Are salary costs too high?

• Is the overtime pay causing this increase, and if so, should more salaried staff be hired instead?

• Is unreimbursed supply cost too high?

• Should less-expensive alternatives be sampled?

The income statement directly provides the data to create a clinically balanced action plan that maximizes profitability.

• 4. List all the department’s assets

Assets are items owned by the department whose value has not yet been recognized. Include the following items:

• Cash or deposits that can be converted to cash quickly if needed (aka liquid assets).

• Money that is owed by insurance payors and patients (aka accounts receivables or AR).

• All unsold/unused products and supplies (aka inventory).

• Money that has been paid in advance before they are due (aka prepaid expenses).

• Capital assets owned by the practice for its long-term growth. These include:

  • ○Land, buildings, and equipment.
  • ○Intangible assets that have future financial benefit, including patents and clinical practice goodwill.
  • ○Any investments held for speculative future growth.

• 5. List all money owed by the department (aka liabilities).

These include:

• Money paid out to maintain day-to-day operations, including rent utilities, supplies, etc.

• Salaries and wages, including overtime pay; payable are payments due to staff for time worked.

• Loan repayment, including interest.

• Taxes (Dean’s tax, practice-management fees) that are still to be paid.

• Debt, including mortgage and leases that are due in their entirety in longer than one year. Note that the short-term portion of this debt is recorded as a current liability.

• 6. Compute the difference (equity) between assets and liabilities in steps 4 and 5 above.

If assets exceed liabilities, equity represents money left over if the practice liquidated on this day, sold all its assets, and paid off all its liabilities. Equity reflects the overall viability of the practice on that very day.

Steps 4–6 represent the balance sheet,⁴ which simply lists assets, liabilities, and equity as a snapshot in time (date indicated on the top of the sheet; Fig. 2). Unlike a P&L statement, it is only good for that specific date.⁵

Fig. 2.

ABC Plastic Surgery LLC balance sheet (note the importance of the date).

The basic formula is balancing both sides (balance sheet). It is described by the acronym ALE:

Assets (cash, property, equipment, investments) = Liabilities (salary, supplies, utilities, rents) + Equity (or Net Assets in NFP)

Logically the formula implies that every item a department owns (assets) must be either:

• Paid for with money borrowed from banks or medical center funds (liabilities);

• Taken as stock from its shareholders (equity). Stock is usually not applicable in not-for-profit (NFP) centers (described later).

• 7. List all sources and amounts of cash that is received, or due to others in the day-to-day functioning (operations) of the department.

This step includes sources and uses of cash from running the clinical practice (professional fees, product-sales, other inpatient and outpatient services); changes in money received or to be received (accounts receivable); depreciation on purchases (eg, laser machine, operating microscope); inventory; and amounts due to vendors or suppliers for goods or services received that have not yet been paid for (aka accounts payable). Add other amounts to be paid, such as wages, income tax payments, interest payments, rent, and cash receipts from the sale of a product or service.

• 8. List all the sources and uses of cash from the department’s investments in its long-term plan.

This could include buying, selling, or leasing office space (eg, new medical spa) or equipment (eg, laser machine), or loans received from the practice-management team, or made out to vendors in prepayments.

• 9. List sources of cash from the hospital or bank, as well as the uses of cash in the account that has not yet been paid (financing).

Financing activities include debt issuance, equity issuance, loans, interest, and repayments of debt.

Steps 7–9 define a cash flow statement (CFS; Fig. 3). The CFS:

Fig. 3.

ABC Plastic Surgery LLC CFS.

• Reconciles the income statement with the balance sheet in three major clinical practice-related activities (operational, investment, and financing).⁶

• Measures the ability of a department to generate enough cash to pay out its expenses and shows where it is coming from and where it is spent.

• Directly reflects the financial health of the department to both, internally, the providers and, externally, the hospital administration.

Not-for-Profit Exceptions⁷:

Departments in NFP medical centers report a different type of FS:

• Instead of a balance sheet, NFPs issue a statement of financial position. Because, by definition, NFPs do not have “equity,” the net balance (assets minus liabilities) is termed “net assets.”

• In lieu of an income statement NFPs issue a statement of activities that lists income from donations, grants, and event revenue.

• Expenses are listed by entity in a separate statement of functional expenses, which reports administrative, program, or fundraising expenses.

INTERPRETING FINANCIAL STATEMENTS

FSs reflect the department’s financial performance.⁸ The balance sheet reports solvency, the income statement indicates profitability, and the CFS reconciles both by transparently indicating how cash is earned and spent (Fig. 4).⁹

Fig. 4.

How the three FSs provide different facets of clinical performance.

FSs are useful in two ways¹⁰:

• By comparative analysis, which reveals how your department is doing within your own medical center, and externally.

• By creating deliverable action items to improve the performance for the next financial year.

• 10. Comparative analysis of FSs.¹¹

Time Comparison

FSs from this year are compared with previous year’s performance. This reveals what works and what does not, in terms of income, expenses, or cash flow. Although this is a useful comparison overall, one must account for external drivers of change (see section later) that could impact financial performance. Further, the frequent changes in healthcare policies and reimbursements alter cash flows, significantly impacting the profits earned.

Interdepartmental Comparison

Useful within a medical center, comparisons with similar departments (size, specialty, and reimbursement rates) identify opportunities for change, as well as discovering what not to do. This may pertain to:

• Cost savings on goods (eg, if orthopedics changed its implant vendors and reduced costs, a similar plan may work for plastic surgery), and

• Services (eg, urology changed its practice-model to a centralized scheduling service (instead of an in-house model) and lost revenues from poor and delayed scheduling practices).

External Comparison

Typically, comparing how your department is performing compared with similar size plastic surgery departments in other institutions (same state or a different state) could help guide improvements. However, because intradepartmental financial data are typically considered private, this is a difficult undertaking.

• 11. Using FSs to make business decisions.

Using the data from the FS, several key performance indicators are calculated. These in turn provide deep insights into the working of the team (Fig. 5). The formula and significance of each index is presented below. In addition, a separate article titled “Balanced Business Decision-Making,” which is part of this mini-series explains in detail how these data, specifically the key performance ratios, are useful for a clinical practice. Relying solely on financial data could be misleading. Combining financial data with two important metrics (clinical productivity and resource utilization) to provide a solid clinical context for decision-making is described in detail in that article.

Fig. 5.

Interaction of the three FSs reveals vital performance data.

Profit and Loss Statement

Income statement metrics such as total revenue growth and gross profit margin are calculated and compared for similar plastic surgery departments (Fig. 6). Using the metrics discussed above, in the example shown, the following conclusions can be drawn:

Fig. 6.

Sample comparison between two departments of plastic surgery at the University of Griffindor and Slytherin.

• Net profit margins for both “University of Slytherin Plastic Surgery,” (SPS) and “University of Gryffindor Plastic Surgery” (GPS) are the same at 28%.

• However, although GPS has a higher net income and revenue growth, its gross profit margin is lower than SPS indicating that the expenses to generate the same income are higher than for SPS.

• On balance, if expenses (wages, supply costs) are controlled, GPS is a better performing department.

• If expenses are expected to rise, then SPS may fare better due to its higher gross profit margin.

Balance Sheet

The balance sheet provides an “at-a-glance” snapshot of the positive net worth of the department (assets minus the sum of liabilities, and net assets (or equity).¹² Balance sheets determine risk: whether there is enough cash to cover the department’s obligations, or whether it has borrowed more money without enough assets to account for them.

A positive balance sheet directly reflects the department’s credit-worthiness. Credit-worthy departments can raise money from the medical center of the practice management group and recruit new faculty based on their financial strengths.

Financial ratios based on the balance sheet indicate liquidity, profitability, solvency, and turnover of a practice.

• Current Ratio = Current Assets ÷ Current Liabilities. Most analysts would consider a ratio of 1.5 to 2 or higher as adequate.¹³

• Quick Ratio = (Current Assets−Inventories) ÷ Current Liabilities¹⁴

• Working Capital = Current Assets − Current Liabilities¹⁵

• Debt-to-Equity Ratio = Total Liabilities ÷ Shareholders’ Equity

WHAT FINANCIAL STATEMENTS HIDE¹⁶

• 12. Garbage in, garbage out.

Inflated inputs to what counts as assets, (liabilities, recoverable debt, actual fees) versus denials can paint a false picture in each of the three FSs. Uncovering them requires a deep scrutiny of each statement and correlating with the other two. If this correlation fails, one must review the inputs carefully.

• 13. Context

FSs need to be compared with previous years’ and other similar competitive departments’ performance to capture trends in their health both internally and on comps. Further, all three FSs need to be carefully evaluated together¹⁷ (eg, CFSs reveal cash accrued from operations, but do not indicate the overall profitability of a department because they do not account for costs or revenues).¹⁸

• 14. A snapshot, not the movie.

Based purely on the status of a department on day of report, a balance sheet lacks the value of a CFS, which presents a better, more real-time status. Correlation is critical.

Similarly, CFSs do not reveal the department’s net income, as it is blind to noncash assets that may be captured in a P&L statement.

• 15. Costs

Typically, FSs use historical costs to reflect the value of the departmental assets. CFSs in particular are prepared on the basis of historical cost, and future/projected cash flows remain unaccounted.

• 16. Change

Operational or demand-supply changes are not included in a typical balance sheet. This can lead to inaccuracies.

• 17. Inflation

High inflation-rates change the actual costs of the assets (when they need replacement), making liabilities significantly higher too. Because FSs do not account for inflation, the volatility of the economy can make FSs unreliable.

• 18. Depreciation

Assets continue to lose their value from the time they are purchased (aka depreciation).¹⁹ This devaluation/depreciation can be missed, thereby inflating the value of the assets making the department look better than it is.

• 19. Cash position

A large positive departmental balance sheet (large equity/cash position) fails to inform what the previous balances were, and what the department’s current obligations cost.²⁰ This misleads a reviewer into believing there is enough cash, without fully accounting for departmental obligations that could quickly deplete its value.

• 20. Unrealistic AR

An unrealistic AR is a very high-risk vulnerability in a balance sheet. Very often, departments that have inefficient fee-collection systems will have very high AR, including debts that are practically unrecoverable. Continuing to show them on the balance sheet presents a false picture of a department’s position.

• 21. Goodwill

A department’s brand, or reputational value, is never captured in the FS, making future predictions based on FSs alone less valuable.

• 22. Charity care, social responsibility

Especially in resource-poor environments, many plastic surgical departments care for the indigent, underinsured, marginalized patients. This increases unrecoverable AR, lowers the reimbursement rate per patient, and affects the bottom line on the FS. The value of these services is not reflected in the FS at all.

• 23. Market uncertainties

Larger variations in demand or supply can affect any department—and any specific FS does not have the ability or the cushion to prepare for these eventualities.²¹

• 24. Historical value only

FSs reflect past performance of any department: they cannot predict future performance.²² Faculty attrition, losing a star performer, changes in reimbursement policies, and governmental regulations can adversely impact the department’s future, which its present-day FS can never predict.

• 25. Trust

FSs are meant to honestly reflect the department’s performance and health. Their preparation relies heavily on integrity and trust. Mistakes (inadvertent or willful) can creep in and misrepresent this information, misleading the faculty and the institution. This is dangerous and needs to be corrected or reported immediately.

CHALLENGES IN OBTAINING FINANCIAL DATA

Some institutions do not share financial data with physicians and limit all decision-making solely to administrators. It prevents a clear understanding of clinical productivity and its value and potential. Changing this approach requires three proactive steps:

1. Physician-administrator partnership: demonstrate to the leadership that you want to work with them and are not adversaries;

2. Financial data competence: develop and showcase your skills at reading, interpreting and acting on financial data inspiring confidence that you “get it”;

3. Shared goals needs shared decision-making: emphasizing to the leaders how sharing financial data enables clinicians to be more accountable. They understand their own performance and its value and cost, and can set goals that improve these metrics. This helps boost performance of all stakeholders, physicians, the team, and their employers alike.

These strategies are explained in detail in a separate article on organizational behavior, an integral part of our clinical practices.

CONCLUSIONS

Clinicians must learn the basics of FSs and what they convey. These essential data ensure a healthy clinical practice, promote growth, enhance provider satisfaction, and ensure that they can focus on delivering care to patients without financial risk.

DISCLOSURE

The authors have no financial interest to declare in relation to the content of this article.