PracticalDermatology

Whether opening another location, purchasing new equipment, or hiring more staff, practice leaders are often faced with decisions that impact their business’ bottom line. To confidently move forward with such significant investments, owners and administrators must consider many financial factors. Usually, this involves answering important questions like:

• How much cash is available for investing?
• How much cash do I need to maintain normal operations and reserves?
• What are the loan products, terms, and rates available at my bank?
• How will the bank determine if I qualify for the loan/the loan terms?

While intuition tells us the practice’s income statement is the best place to find these answers, it is the balance sheet that provides a complete picture of your financial standing. This article will examine the important role your balance sheet plays in understanding, updating, and evaluating your company’s well-being, ultimately allowing you to make better business decisions.

Breaking Down Your Balance Sheet

In simple terms, the balance sheet provides a snapshot of the health of your business by summarizing what the company owns and owes. A quick glance at a balance sheet shows us:

• how much cash is in the bank,
• the assets we own (and can sell),
• our liabilities (bills and loans we owe), and
• the equity in the company.

The balance sheet follows a simple equation: Assets = Liabilities + Equity.

Assets are broken into two major categories: current and long-term. Current assets include cash, cash-equivalents (like short-term liquid investments), accounts receivable, and inventory. Long-term assets include items such as leasehold improvements, medical equipment, office equipment, furniture, and fixtures.

Liabilities are also segregated into current and long-term categories. Current liabilities include payroll, accounts payable, and a current portion of long-term debt. Long-term liabilities include equipment loans or term loans greater than 1 year.

Equity—the value of the owners’ stake in the company—varies greatly by company, as it depends on fiscal policy.

Another key component of a healthy balance sheet is the retained earnings, or the company’s profits after all its obligations are paid. Retained earnings may be distributed to the owners or kept in the company. Many of our clients favor owner distributions. While this is certainly an acceptable fiscal policy, we typically recommend setting aside 3 to 6 months’ worth of expenses as a safety net. Setting aside cash for a rainy day strengthens the balance sheet and gives you more purchasing power. As many of us experienced in 2020, retained earnings leave the company in a better position in emergency situations.

Internal Decision-making

Understanding your balance sheet does more than reveal your financial standing; it allows you to improve the decision-making process. However, you must have the most relevant data at your disposal to make the best choices. So, while many practices prefer to have an accountant reconcile adjustments at the end of the year, this is not ideal. An outdated balance sheet cannot give an accurate snapshot of your business’ health; we recommend updating your balance sheet monthly.

With your up-to-date balance sheet, you can make more informed business decisions. For example, let’s imagine you’re looking to purchase capital equipment. To determine how to finance this purchase, you would review your balance sheet and ask the following questions:

1. Do you have the cash to make the purchase?

2. If you used cash to make the purchase, would you have the necessary remaining cash (also referred to as working capital) to cover operating expenses?

3. Is the cost of capital favorable enough that it makes sense to finance the equipment? In other words, is your balance sheet healthy enough to secure good loan terms and finance the purchase?

The answers provided by your balance sheet will help you establish the most financially sound way to move forward with purchasing new equipment.

A Lender’s Perspective

Just as you use your balance sheet to help with decision-making, lenders use it to discern your loan eligibility. For this reason, it’s crucial that your balance sheet accurately reflects ALL your finances. This is worth mentioning because most practices use cash-based accounting, meaning they recognize revenue when cash is received and expenses when they are paid. Since these cash-based balance sheets do not consider net working capital (the collectable value of accounts receivable less accounts payable), they do not present the whole financial picture.

For this reason, practices often task their accountant with making key adjustments to practice balance sheet statements for things like inventory and net working capital. These adjustments allow the organization to present a complete picture of its financial standing, making securing funding more likely. Likewise, you will want to adjust your balance sheet to include this data prior to applying for financing, as it adds to your business’ value and verifies its health. Inventory is the other balance sheet item that should be updated before finalizing the value of the business for lender review.

Since the balance sheet is often the first report lenders evaluate when considering an entity’s value, knowing how to interpret it from their perspective is useful if you’re considering financing. This point of view can help you determine whether your business qualifies for financing and how generous or stringent the loan terms may be. Table 1 breaks down common balance sheet ratios, how they are calculated, and what they indicate. Any time you are applying for financing, the lender will evaluate your business, in part, based on these ratios.

To illustrate how lenders practically apply these ratios, let’s consider a client who was recently seeking financing for new equipment. The practice’s current ratio and debt-to-equity ratio were below the banker’s standards due to the company’s fiscal policy of quarterly ownership distributions, which depleted its cash reserve. Therefore, the bank required the owners to sign personal guarantees. The owners—who did not want to put their personal holdings at risk for the company—chose instead to change the organization’s fiscal policy and skip quarterly distributions. This policy change allowed the practice to meet the bank’s required current ratio of 3:1 and secure financing without personal guarantees.

Your Balance Sheet

To get an accurate picture of your practice’s financial standing, you must understand the numerous moving parts that compose your practice’s balance sheet. Knowing how lenders will interpret your balance sheet, understanding what cash-basis elements may not appear, and taking the steps to include this information allows you to present an accurate financial picture of your practice. If you find you’re not meeting your lender’s standards, adjusting fiscal policies that impact key ratios can help you secure financing. By keeping your balance sheet updated, you will greatly improve your chances of making sound financial decisions.