How to Read a Balance Sheet

A balance sheet provides an essential picture of your practice's financial health, yet, amazingly, few physicians can make heads or tails of one. Medical schools don't teach that stuff, of course, but most doctors don't see a reason to learn about it anyway. After all, that's why you pay an accountant, right?

But it's your practice. You can't really get a handle on its finances and how they are trending unless you can interpret financial statements. With a basic understanding of what's going on, you'll be far better equipped to understand the advice accountants and other financial professionals give you, and you won't need to rely on them to make all the crucial decisions about your practice's future.

A balance sheet, like a blood pressure reading, is a snapshot—a measure of a practice's financial situation at a given point in time. And like a blood pressure reading, its main usefulness lies in how it compares with other snapshots at other times.

Essential components of a balance sheet include assets (what your practice owns outright), liabilities (what it owes others), and equity (value added to the practice, such as financed equipment and profits retained within the business.)

As the name implies, a balance sheet must balance. The fundamental equation is assets equal liabilities plus equity. In other words that I find easier to grasp: Equity equals assets minus liabilities.

Assets are typically divided into current and long term. Current assets are those that could be liquidated within 1 year, such as cash, accounts receivable, and inventory if you stock products for resale. Long-term assets include buildings, furniture, equipment, and other durable goods, less depreciation (the taxable value they have lost since they were purchased).

Liabilities are similarly classified as current and long term. Current liabilities must be paid within the next year and include accounts payable, wages, and payroll taxes. Long-term liabilities, such as mortgages, loans, and equipment leases, are due over a period of years.

Equity is basically the owner's money—theoretically what would be left if you liquidated all the practice's assets and paid all its liabilities. It is not a realistic measure of a practice's net value since it doesn't reflect the current, open-market value of assets and doesn't consider intangibles such as good will. That's not what a balance sheet is designed to measure.

So what does a balance sheet measure? It keeps track of two of the three key elements of financial strength: liquidity and solvency. The third element, profitability, is measured with a separate tool, the income statement.

Liquidity, as calculated by current ratio (current assets divided by current liabilities), is a measure of the practice's ability to pay its bills over the next year. Your ratio should be at least 2:1. If it's lower, the practice is probably carrying too much debt and may run into trouble, particularly if too many bills come due at once.

Solvency, or debt-to-equity ratio (total liabilities divided by total equity), is a measure of borrowing power. A 3:1 ratio is the upper limit of normal for most banks, meaning for every $3 in debt there is at least $1 in equity (owner's money). Any higher and the practice will not be able to finance expansion, or even weather an economic downturn, because loan money will not be available.

The time to do these calculations is not when you apply for a loan, but long before—by assembling and analyzing balance sheets regularly—so that negative trends can be identified and turned around.

Hopefully, the importance of regular financial analysis is becoming obvious.

Numerous other useful bits of information—asset allocation, collection efficiency, and cash utilization—can be gleaned from a balance sheet if you know what to look for.

So how often should you review your practice's balance sheet? In an established practice, during relatively stable economic times, once a year may be sufficient. If your practice is new, though, or you're having liquidity problems, more frequent analysis, perhaps quarterly, is necessary. When in doubt, have a look. Balance sheets are neither expensive nor difficult to produce. With modern financial software, a few keystrokes on your accountant's computer are usually all that's necessary.

It may take you awhile, however, to feel comfortable analyzing financial statements. You didn't master medical diagnosis and treatment overnight, and this skill won't come instantaneously either.

I suggest you ask your accountant to walk you through your practice's balance sheet the first few times. Ask questions. Get a feel for what he or she sees within it, and take the opportunity to review your plans for the future. A good accountant will welcome the chance to show you the financial ropes and to help you work toward your long-term practice goals.

A balance sheet provides an essential picture of your practice's financial health, yet, amazingly, few physicians can make heads or tails of one. Medical schools don't teach that stuff, of course, but most doctors don't see a reason to learn about it anyway. After all, that's why you pay an accountant, right?

But it's your practice. You can't really get a handle on its finances and how they are trending unless you can interpret financial statements. With a basic understanding of what's going on, you'll be far better equipped to understand the advice accountants and other financial professionals give you, and you won't need to rely on them to make all the crucial decisions about your practice's future.

A balance sheet, like a blood pressure reading, is a snapshot—a measure of a practice's financial situation at a given point in time. And like a blood pressure reading, its main usefulness lies in how it compares with other snapshots at other times.

Essential components of a balance sheet include assets (what your practice owns outright), liabilities (what it owes others), and equity (value added to the practice, such as financed equipment and profits retained within the business.)

As the name implies, a balance sheet must balance. The fundamental equation is assets equal liabilities plus equity. In other words that I find easier to grasp: Equity equals assets minus liabilities.

Assets are typically divided into current and long term. Current assets are those that could be liquidated within 1 year, such as cash, accounts receivable, and inventory if you stock products for resale. Long-term assets include buildings, furniture, equipment, and other durable goods, less depreciation (the taxable value they have lost since they were purchased).

Liabilities are similarly classified as current and long term. Current liabilities must be paid within the next year and include accounts payable, wages, and payroll taxes. Long-term liabilities, such as mortgages, loans, and equipment leases, are due over a period of years.

Equity is basically the owner's money—theoretically what would be left if you liquidated all the practice's assets and paid all its liabilities. It is not a realistic measure of a practice's net value since it doesn't reflect the current, open-market value of assets and doesn't consider intangibles such as good will. That's not what a balance sheet is designed to measure.

So what does a balance sheet measure? It keeps track of two of the three key elements of financial strength: liquidity and solvency. The third element, profitability, is measured with a separate tool, the income statement.

Liquidity, as calculated by current ratio (current assets divided by current liabilities), is a measure of the practice's ability to pay its bills over the next year. Your ratio should be at least 2:1. If it's lower, the practice is probably carrying too much debt and may run into trouble, particularly if too many bills come due at once.

Solvency, or debt-to-equity ratio (total liabilities divided by total equity), is a measure of borrowing power. A 3:1 ratio is the upper limit of normal for most banks, meaning for every $3 in debt there is at least $1 in equity (owner's money). Any higher and the practice will not be able to finance expansion, or even weather an economic downturn, because loan money will not be available.

The time to do these calculations is not when you apply for a loan, but long before—by assembling and analyzing balance sheets regularly—so that negative trends can be identified and turned around.

Hopefully, the importance of regular financial analysis is becoming obvious.

Numerous other useful bits of information—asset allocation, collection efficiency, and cash utilization—can be gleaned from a balance sheet if you know what to look for.

So how often should you review your practice's balance sheet? In an established practice, during relatively stable economic times, once a year may be sufficient. If your practice is new, though, or you're having liquidity problems, more frequent analysis, perhaps quarterly, is necessary. When in doubt, have a look. Balance sheets are neither expensive nor difficult to produce. With modern financial software, a few keystrokes on your accountant's computer are usually all that's necessary.

It may take you awhile, however, to feel comfortable analyzing financial statements. You didn't master medical diagnosis and treatment overnight, and this skill won't come instantaneously either.

I suggest you ask your accountant to walk you through your practice's balance sheet the first few times. Ask questions. Get a feel for what he or she sees within it, and take the opportunity to review your plans for the future. A good accountant will welcome the chance to show you the financial ropes and to help you work toward your long-term practice goals.

A balance sheet provides an essential picture of your practice's financial health, yet, amazingly, few physicians can make heads or tails of one. Medical schools don't teach that stuff, of course, but most doctors don't see a reason to learn about it anyway. After all, that's why you pay an accountant, right?

But it's your practice. You can't really get a handle on its finances and how they are trending unless you can interpret financial statements. With a basic understanding of what's going on, you'll be far better equipped to understand the advice accountants and other financial professionals give you, and you won't need to rely on them to make all the crucial decisions about your practice's future.

A balance sheet, like a blood pressure reading, is a snapshot—a measure of a practice's financial situation at a given point in time. And like a blood pressure reading, its main usefulness lies in how it compares with other snapshots at other times.

Essential components of a balance sheet include assets (what your practice owns outright), liabilities (what it owes others), and equity (value added to the practice, such as financed equipment and profits retained within the business.)

As the name implies, a balance sheet must balance. The fundamental equation is assets equal liabilities plus equity. In other words that I find easier to grasp: Equity equals assets minus liabilities.

Assets are typically divided into current and long term. Current assets are those that could be liquidated within 1 year, such as cash, accounts receivable, and inventory if you stock products for resale. Long-term assets include buildings, furniture, equipment, and other durable goods, less depreciation (the taxable value they have lost since they were purchased).

Liabilities are similarly classified as current and long term. Current liabilities must be paid within the next year and include accounts payable, wages, and payroll taxes. Long-term liabilities, such as mortgages, loans, and equipment leases, are due over a period of years.

Equity is basically the owner's money—theoretically what would be left if you liquidated all the practice's assets and paid all its liabilities. It is not a realistic measure of a practice's net value since it doesn't reflect the current, open-market value of assets and doesn't consider intangibles such as good will. That's not what a balance sheet is designed to measure.

So what does a balance sheet measure? It keeps track of two of the three key elements of financial strength: liquidity and solvency. The third element, profitability, is measured with a separate tool, the income statement.

Liquidity, as calculated by current ratio (current assets divided by current liabilities), is a measure of the practice's ability to pay its bills over the next year. Your ratio should be at least 2:1. If it's lower, the practice is probably carrying too much debt and may run into trouble, particularly if too many bills come due at once.

Solvency, or debt-to-equity ratio (total liabilities divided by total equity), is a measure of borrowing power. A 3:1 ratio is the upper limit of normal for most banks, meaning for every $3 in debt there is at least $1 in equity (owner's money). Any higher and the practice will not be able to finance expansion, or even weather an economic downturn, because loan money will not be available.

The time to do these calculations is not when you apply for a loan, but long before—by assembling and analyzing balance sheets regularly—so that negative trends can be identified and turned around.

Hopefully, the importance of regular financial analysis is becoming obvious.

Numerous other useful bits of information—asset allocation, collection efficiency, and cash utilization—can be gleaned from a balance sheet if you know what to look for.

So how often should you review your practice's balance sheet? In an established practice, during relatively stable economic times, once a year may be sufficient. If your practice is new, though, or you're having liquidity problems, more frequent analysis, perhaps quarterly, is necessary. When in doubt, have a look. Balance sheets are neither expensive nor difficult to produce. With modern financial software, a few keystrokes on your accountant's computer are usually all that's necessary.

It may take you awhile, however, to feel comfortable analyzing financial statements. You didn't master medical diagnosis and treatment overnight, and this skill won't come instantaneously either.

I suggest you ask your accountant to walk you through your practice's balance sheet the first few times. Ask questions. Get a feel for what he or she sees within it, and take the opportunity to review your plans for the future. A good accountant will welcome the chance to show you the financial ropes and to help you work toward your long-term practice goals.