Comprehending Business Finance
Beware of little expenses; a small leak will sink a great ship.
— Benjamin Franklin
INTRODUCTION
Most people first think of numbers and computations when asked about the discipline of finance. Although the association of finance to these is obvious, the understanding of their meaning is perceived to be far from simple. The addition of complex-appearing legal documents to these numerical values further adds to the intimidation. Business finance describes how a company manages its money through the use of various financial statements and their associated calculations.
Similar financial assessments are routinely performed by eye care providers at their offices and homes without realizing it. The only difference is that these calculations are done without using the formal names of the concepts seen in this field. For example, the development of new technology occurs at a rapid pace in our field of eye care. However, these advancements do not come free. Providers must routinely ask themselves if and when an additional piece of capital equipment will be worth the amount of money invested. In finance terms these questions are answered with return on investment (ROI), net present value (NPV), and break-even analysis.
This chapter establishes the groundwork for the principles, calculations, and standardized documents utilized in business finance. However, it focuses on the application of the financial statements as it relates to common situations an eye care provider encounters in practice. This is important as each of them provides a different vantage point when evaluating the status of a company. The goal is to enable the practitioner to feel comfortable when reviewing this information and using it in practical ways. More importantly, this section empowers the reader to know when things do not make sense to raise awareness for the need of correction.
WHAT IS BUSINESS FINANCE?
When most people are asked to word associate with the term business, one of the popular responses is “money.” Certainly, the creation of wealth is a metric that is commonly used to assess the success of any business venue. Similar to how we need to evaluate the status of every different system in the human body to gauge its overall health, a proper understanding of how money is viewed though different lenses in a business is critical to evaluate its well-being.
The biggest hurdle in this endeavor is learning the basic terms, understanding the different financial statements, and evaluating the implications of these put together. Once these fundamental pieces are appreciated, the true assessment of a business can occur. This allows taking a complex entity and breaking it down to its simpler units. These smaller pieces can each present a unique view of the organization’s money. In particular, this exercise explains the makeup of a business at a particular point in time, the degree of its success, and the way in which it transfers money over time. The result is an effective way to analyze each dimension of this complicated business unit to understand it as a whole.
However, limiting the application of this information to simply assessing the financial status of business would be shortchanging its value. This is the equivalent of someone taking another person’s recipe and following it line by line every time to prepare the same meal. Why limit oneself to simply being a follower when there is an opportunity to be a leader? The successful business person takes that unique knowledge of how the pieces fit together and then effectively makes changes in the process to continually improve. The true goal should be to create an even better tasting meal. This chapter (and really, this whole book) gives you the ingredients and steps, but it will be up to you to make your own unique dish. In business, just as in life, it is this little bit of extra effort and willingness to try something different that separates the ordinary from the extraordinary.
BUSINESS FINANCE IN EYE CARE
The significance of business finance in the eye care practice is assumed to be the ability to comprehend the relative wealth of an organization. However, the application of business finance extends beyond this to the function of what the business is doing with its money. These advance topics and their utilization separates the successful organizations from the failing or even mediocre ones. Those with a firm understanding of their financial status capitalize on that information to make sound business decisions. The companies that either do not have these data, or even worse have no awareness to them, make critical choices about the future while being in a fog. At some point, this haphazard style of financial decision making will be costly. The essential skills in business finance for the eye care practitioner to exercise are the following: learning finance basics, appreciating the balance sheet statement, understanding the income statement, following the cash flow statement, and valuing money.
Importance
The financial component in any business is an integral part of it. There is no special exception for eye care practices. Businesses cannot operate without viable financial support, regardless of whatever good or service is being provided to the consumer. The common interface between an eye care practitioner and this area of the company are the traditional financial statements along with their associated computations. Every individual that aspires to obtain a better understanding of these statements, and eventually the finances overall, needs to learn the fundamental terms and ideas on which they are built.
Keywords
Business finance: The study of a company’s management of money
Ledger: A company’s collection of financial accounts
Controller: The individual responsible for a company’s accounting (synonymous with comptroller)
Revenue cycle manager: The individual within a company that oversees the process (revenue cycle management or RCM) that tracks the payments from patients in a healthcare system from the moment of an encounter presentation until the balance is posted and paid
Generally accepted accounting principles (GAAP): A collection of accepted accounting rules and guidelines set forth by the Financial Accounting Standards Board
Financial Accounting Standards Board (FASB): An organized group of business professionals, including accountants, that provides the standards for financial accounting through the use of GAAP
Book value: The value of something as documented in the financial books of a company
Pro forma: A model of expected future performance based on historical data and projections that is formatted using the same guidelines as current financial statements
Stock: A representation of ownership in a corporation
Common stock: A rudimentary type of stock that offers its owners the lowest rights, including the receipt of dividends when offered or assets should the company be liquidated
Preferred stock: An advanced type of stock where owners are given special considerations during times of dividend distribution or asset allocation for cases of liquidation
Profitability ratios: A set of financial calculations that describes profitability based on financial markers
Return on investment (ROI): A calculation used to quantify the relationship between the creation of profits and payment of costs for an investment
Leverage: The use of credit from lenders to create profits
Debt-to-equity ratio: A representation of how much money a company owes in debt relative to the amount of investor equity
Debt: The condition of owing something to another person, business, or institute
Bad debt: A debt that is owed but cannot be recovered
Line of credit: A form of financing that behaves like a short-term loan from a bank to a company
Credit limit: The maximum amount of credit a company can utilize from a given financial agreement, like a line of credit
Principal: The amount of money borrowed in a loan that still needs to be repaid in addition to the accumulating interest after a payment is made
Amortization schedule: A schedule that shows the breakdown of a payment for a loan over its payback period that illustrates the amount of money that goes interest and principal
Applications
The strategic application of business finance is a fundamental characteristic of an elite eye care practitioner. This does not imply that the provider needs to extensively understand every aspect of a practice’s financial statement. As a leader in the organization, the role of the practitioner is to maximize the skills of its employees, but also outsource for help when needed. This includes recruiting the assistance of qualified accountants. The reality is that the provider must know how to harness these talents to effectively use business finance as an advantage. The key is to be able to look over financial statements and identify where there are concerns. Some describe this as “passing the sniff test.” Does it smell right?
The core of business finance involves the use of a company’s ledger. These individual financial statements describe critical information about the practice. They are managed by select financial personnel in the practice such as the controller (also known as the comptroller) with a close interaction involving the revenue cycle manager. However, it should follow the generally accepted accounting principles (GAAP) set forth by the Financial Accounting Standards Board (FASB) to be useful and legally compliant documents.1 It is important to note that the numbers in the financial statements represent the book value of the line item, which is also used for official, legal purposes. These documents can be formatted to be historical or pro forma. The smart practitioner does utilize the pro forma statements, but also understands that these are projections based on prior data. Care should be taken to comprehend how this information was calculated and what it means.
The successful provider is also familiar with a set of common topics encountered in this space. The first includes the use of stocks for ownership in a company. The issuance of stock is a method of raising funds for the organization. The type and number of stocks will vary from one setting to another depending on the company’s needs. For example, an S corporation business structure will issue one type, or common stock. Other entities will offer different stock with special rights, known as preferred stock, in addition to common stocks.1 The classes of stocks carry different meanings, such as in times of dividend distribution or company liquidation.
The next useful topic to familiarize oneself is the particular ratios used in business finance. The first is a series of profitability ratios that relate the ability to generate profit to a specific financial marker. These include return on assets, return on equity, return on sales, and gross margins. Each of these has a different meaning that signals to the reviewer the effectiveness of profit making.
Another common ratio is ROI. However, its calculation does not have a specific set of markers that are agreed upon for use in its analysis. It will change from business to business with the method they want to define. The takeaway is that ROI represents how successful the endeavor was at generating profit based on the investment needed to initiate it.
An additional important ratio is debt-to-equity. This number is important when lenders for a loan are evaluating the company as they look for situations where debt is low and equity is high, or a low valued debt-to-equity ratio. An adjunctive piece of information they also evaluate beyond the debt total is the amount of bad debt. This includes debt that cannot be recovered, such as owed payments from a buyer that has gone bankrupted.
The last general topic includes loans and the mechanics of how they operate. A loan is an advancement of cash or credit from the lender to the debtor. The debtor can use those funds now and in return pays back the lender the amount loaned along with interest. There are many types of loans. One specific example is a line of credit. This is a useful short-term loan where the practice can borrow up to a credit limit for use as needed. The benefit is that the unused portion does not accrue interest but remains accessible for utilization.
In the repayment process, the amount borrowed is called the principal. Successful repayment of the loan means that the principal was paid back. However, interest accrues as long as there is a remaining balance. Every payment from the debtor first goes to cover the interest that accumulated since the prior payment, and the rest of the amount goes to paying down the principal. An amortization schedule is used to describe how the payment is allocated to the interest and principal (Figure 9-1). The effect is that the amount paid to interest instead of principal is the highest at the beginning of the repayment process. A great approach to reducing principal quickly is to pay extra at the beginning beyond the minimum amount required. Generally, this additional payment can then be applied to the principal without being subject to interest.
Immediate Action Items
Do you understand your practice’s finances? Start by identifying where its ledger is and who manages it such as your chief financial officer, controller, or accountant. Take time to review the accounts to get a sense of what comprises it. Although you will not understand everything, the first step begins by breaking the immense resistance to look at anything in the form of financial documents. Do not be overwhelmed. Take this task in small pieces. You will soon notice common trends and familiar principles based on the basic keywords already presented in the chapter. These documents will make more sense as you progress through the next section. Refer to your respective manager of the ledger with any additional questions to fill in the details. Not only will this provide the groundwork to grow your financial assessment skills, but it will also develop your relationship with those overseeing this critical aspect of your business. You successfully learned how the human eye works—you can do this!
Figure 9-1. Example of an amortization schedule.
Appreciating the Balance Sheet Statement
Importance
There are few official accounting statements that complement one another to provide businesses a look into their financial status.2 Each assessment has its own purpose and value. The successful eye care practitioner has the appropriate training to knowledgeably review these documents, ask critical questions, and analyze the results to provide an understanding on the company’s well-being. Each of these documents provides unique information; therefore, they must be used together to get the complete picture of the organization.
The balance statement illustrates what a business looks like financially at a specific moment in time. It can be split into 3 useful components that can be further broken down to provide more information. The reviewer of the document will see what the business has, owes, and is worth. Respectively, these are termed assets, liabilities, and equity.1 Their relationship is expressed by the equation that assets equal the sum of liabilities and equity. This statement enables an efficient overview of what is occurring currently but also has the capabilities to provide much more detailed perspective in each of those vital areas. The result is a proper assessment of the organization’s areas of strengths and weaknesses. Elite businesses add to that evaluation by creating goals for improvement and implementing plans for action.
Keywords
Balance sheet: A financial statement for a company that provides a detailed breakdown of how it is composed at one particular instant in time using assets, liabilities, and shareholders’ equity
Asset: A valued resource owned by a company
Liability: An obligation that a company owes
Shareholders’ equity: A representation of value held by an owner in a company that is determined by the sum of capital stock and retained earnings
Liquidity: A description of how easy an asset can be converted to cash
Current assets: A collection of assets that will routinely be converted to cash within the next year, including cash on hand, accounts receivable, inventory, and prepaid expenses
Cash: The most liquid form of money
Accounts receivable (AR): A collection of payments that are owed to the company
Inventory: The sum of all final products ready for sale along with any available raw materials
Prepaid expenses: The expenses that have been paid already but have not been used
Noncurrent assets: The set of assets that are not sold routinely and, therefore, are not converted to cash
Intangible assets: The set of assets owned by a company that have value but are not readily measured
Net fixed assets: The resultant of subtracting accumulated depreciation from the cost of fixed assets
Cost of fixed assets: The collection of property and equipment owned and used by the practice for its routine operations
Depreciation: A term used to express the decrease in value of an asset over time due to natural wear and tear from use
Accumulated depreciation: The total depreciation collected since the acquisition of an asset
Accounts payable (AP): A collection of bills or credits a company owes another party that needs to be paid
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