What to Use, When to Use It
Accounting in health care is very important in order to understand the economic health of the organization. Without understanding the financial status of the organization, directionality of growth and prosperity is certainly in question; however, with financial statements as a guide, one can make informed and logical decisions to develop a strategic plan to direct organizational growth in a fiscally responsible nature.
Ittelson (2009) and Penner (2004) outline the various financial statements and how they are used. I will review three financial statements (the balance sheet, the income statement, and the cash flow statement) and the means to use the values on these statements to provide meaning, through the use of ratio analysis, of the fiscal health of the organization.
The balance sheet is one of two main organizational financial statements. Ittelson (2009) outlines the balance sheet as showing assets = liabilities + worth, in that the value of an organization’s assets (or, what an organization has) is the sum of the organization’s liabilities (or, what is owed) and worth (or, the value of the organization to the owners).
Assets are usually listed on the balance sheet in order of liquidity and include everything valuable within an organization, including cash, accounts receivable, any inventory (included at depreciated value, if applicable), expenses that were prepaid, and any other intangibles that offer intrinsic value to the organization (Ittelson, 2009; Penner, 2004).
Liabilities, according to Ittelson (2009), are listed on the balance sheet as groupings of term (short- and long-term) and include current liabilities (accounts payable, expenses, portions of contracted debt currently payable, and taxes), long-term debt (or, contracted debt payable outside of the bounds of the current statement), and shareholder equity (or, the sum of capital stock value and the amount of retained earnings). The shareholder equity is also the worth of the organization.
By definition, the balance sheet must be balanced in the end with the value of the assets being the total liabilities and equities offset by the shareholder equity. The balance sheet, with this comparison, provides the fixed financial picture of the organization at any particular date.
The income statement, which describes an organization’s profitability, is the other main financial statement of an organization (Ittelson, 2009). The income statement details the value of inputs and expenses required to develop a specific income for a defined period of time; however, according to Ittelson (2009), it does not provide timing on payments or an assessment of how much cash the organization has on hand.
The income statement accounts for the gross margin (net sales vs. cost of goods sold), operating expenses (e.g. sales and marketing, research and development, and general and administrative expenses), interest income, and income taxes to derive net income (Ittelson, 2009; Penner, 2004).
As the organization’s net income increases, reflections of increased assets or decreased liabilities will be seen on the balance sheet. Likewise, this link will also show the reverse to be true as decreased assets or increased liabilities (Ittelson, 2009).
Cash Flow Statement
The cash flow statement, as noted by Ittelson (2009) and Penner (2004), simply describes the movement, or flow, of cash within the organization. Starting with the amount of cash on hand at the beginning of the reporting period, the cash flow statement tracks how cash is paid and received, such as cash receipts and disbursements, purchases of fixed assets, money borrowed, stock sales, and taxes paid, ending with the amount of cash on hand at the end of the reporting period. However, this statement does not account for receiving inventory or delivering finished products to customers as these would account for non-cash transactions. Only when the organization pays for the inventory or the customer pays for the product would it affect the cash flow statement.
According to Ittelson (2009), the cash flow statement describes the velocity of cash, exclusively, within an organization, and accounts for a portion of the organization’s assets as well as some new liabilities (such as a new mortgage or loan) and old liabilities (debt being paid).
Although the financial statements described above describe the general financial health of an organization, the relationships of particular items within those reports can provide more specific indicators of financial condition (Ittelson, 2009; Penner, 2004). The use of these relationships is called ratio analysis.
Ratio analysis can help to determine factors, such as profitability, liquidity, asset management, and leverage. Ratio analysis can also help to compare various organizations among various industries by using a statement conversion to “common size” (Ittelson, 2009, p. 194), which represents items as percentages of the largest item on each statement.
Profitability, according to Ittelson (2009), is the ability of an organization to generate a return of profit on equity, sales, and assets. The gross margin, as a percentage, is also a profitability ratio analysis.
Liquidity, as opposed to the measure of returning a profit, is a measure of an organization’s ability to maintain a financial cushion and show financial strength.
Asset management ratios are measures of the efficient or inefficient use of assets and the time generally taken from using inputs to receiving payment. According to Ittelson (2009), “asset management ratios provide a tool to investigate how effective in generating profits the [organization’s] investment in accounts receivables, inventory [sic] and fixed assets is” (p. 198).
Leverage, much like liquidity, is a safety measure that describes the organization’s ability to absorb loss and meet obligations. The leverage safety cushion is also referred by Ittleson (2009) as the “equity cushion” (p. 202). Too much leverage is risky, but too little leverage decreases the ability to maximize profit and growth. Leverage is the use of other people’s money to augment the owner’s investment in order to maximize profits.
By using strict accounting guidelines and keeping accurate records, financial statements can be prepared that will provide insight into the financial health of an organization. These statements can help to compare the financial status of the organization at different times or to compare the organization with other organizations. Also, accurate financial statements will help to draw investors, secure lending opportunities, and comply with legal requirements.
Ittelson, T. R. (2009). Financial statements: A step-by-step guide to understanding and creating financial reports (Revised and expanded ed.). Pompton Plains, NJ: Career Press.
Penner, S. J. (2004). Introduction to health care economics & financial management: fundamental concepts with practical applications. Philadelphia, PA: Lippincott Williams & Wilkins.