How to Read Financial Reports
The ins and outs of key financial statements in a physical therapy business
By Ken Erb, PT
“What’s the difference between a balance sheet and a profit and loss (P&L) statement?”
Eight years ago, when my practice was financing the build for our second office, I started asking this question to every student who rotated through our clinics. Can you guess how many of those students have since correctly answered that question?
One in eight years. And these are doctoral candidates. Clearly, as we advocate for more young professionals to join us in private practice, we are going to need to do the hard work of shoring up some of the blind spots that we all face when we are newly minted physical therapists.
Knowing how to read a financial statement is a key skill for anyone who wants to understand their own business or evaluate the value of another business. This knowledge is necessary for you to understand tax implications, potential audit/compliance concerns, and whether or not a business is running efficiently. In addition, this skill helps you evaluate the sale of your practice to interested buyers and helps guide your decisions if you are considering the purchase of another practice.
Here’s a fact that we don’t talk about: physical therapists can successfully run a practice for many years without REALLY understanding how to read financial statements. A good accountant can cover up a lot of insufficiencies in this regard, but are they also acting as enablers for a business owner in need of understanding?
Being able to “speak the language” is a competitive advantage for any business. Fortunately, the language of relevant financial reporting for physical therapy practices is pretty simple and straightforward. Knowing how to create, read, and interpret a few key financial statements can give you an advantage not only when it comes to valuing your business but also when seeking capital (loans or investment), making important decisions about how to allocate your resources, explaining your practice’s success or failure to partners, and running your day-to-day operations.
PROFIT AND LOSS STATEMENT
What old-schoolers might call an “income statement” is the first key element in terms of financial reporting. In short: Over any given period of time, how much money does a business spend and how much money does it bring in?
Your business’s P&L can be easily found under “Company & Financial” reports in QuickBooks. Very simply put, income is communicated in the top portion of the report, expenses in the bottom, and at the very bottom, your (Bottom Line) number is either positive (Profit) or negative (Loss). This is your “Am I profitable?” report, and it seems easy enough, but, of course, the devil is in the details. Like anything, there is a wealth of nuance inside a company’s P&L.
If you are using your P&L for your own purposes, most times (especially in small practices) it is obvious to you what costs make up each line-item expense just by looking at it. Don’t make the mistake of thinking that this same understanding of your P&L will be so obvious to outside parties. As such, anytime you are going to share your P&L with an outside party, always include an “Administrative Discussion/Analysis.” This will allow you to clear up any confusion or clarify and explain anything that might look like a financial abnormality to an outsider.
Want to know some common examples of what’s included in an Admin D/A? A deeper dive into the P&L can be found online.
While the P&L does a nice job of telling us whether or not we are actually making money on a monthly, quarterly, or yearly basis, it does not really tell the whole story of the financial health of your business. How interested would you be in buying a business that creates some profit every month for its owners, but that also owes enormous sums of money to debtors, banks, founders, vendors, and other agencies?
The balance sheet is a report that can give us that information and more. Think of the balance sheet as giving you the ability to describe your business’s “net worth,” technically called its “book value,”
Balance sheets have three components: assets, liabilities, and owner’s equity. So how does it “balance,” you might ask? The company’s assets must add up to the sum of its liabilities and owner’s equity.
Think of assets as what the company owns (e.g., cash, equipment, inventory) and liabilities as what it owes (e.g., “accrued” expenses and accounts payable that you haven’t sent in yet, loans, etc.). Subtracting liabilities from assets gives you owner’s equity, and voilà, the balance sheet balances!
When you run your balance sheet (also found under Company & Financial in QuickBooks Reports), owner’s equity likely will consist of “retained earnings” (earned money that’s not paid to owners) and “capital stock” (your initial investment) — or similar terms, depending on how your accountant set up your business.
For more on retained earnings, see the online content.
For mature businesses, it is often helpful to consider that, for better or worse, the balance sheet is where the P&L ends up. A profitable business adds cash to its “bottom line” on the P&L every period, and as that excess cash is added to bank accounts, the balance sheet increases its “assets.” If liabilities don’t rise, the “owner’s equity” must rise equal to the asset difference for the balance sheet to remain balanced, and thus the owners have more money sitting in the business. Their share of the company is more valuable than the last time a balance sheet was run.
A business that is having trouble with profitability will have a negative bottom line on the P&L, and this will manifest itself with either decreased assets (many times, these are bank accounts with less money in them than the previous time you ran a balance sheet) or increased liabilities (if, for example, you had to borrow money to make up the shortfall caused by your lack of profitability). The collective owners of this business now have shares that are less valuable than they were the last time you checked.
Another way to conceptualize the balance sheet is by simply thinking, “If this business were to come to a full stop today, pay off all its debts, and sell all its assets, what would be left over for the shareholders to split up?”
Unlike the P&L, which is a snapshot of how a business is doing over a set period of time (like a movie showing the practice’s financial performance), a balance sheet is a snapshot of the overall financial health of a business at any given point in time. Typical balance sheets will have a title like “Balance Sheet for Sunrise Physical Therapy as of April 3, 2022.” Since the value of both liabilities and assets change over time, the balance sheet only looks at the “net worth” of the business at a fixed point.
Want to know what is important to banks when they look at your balance sheet?
CASH FLOW STATEMENT
Balance sheets and P&Ls are great, but when bills come due, cash is king.
Imagine a poker player who has only a few chips in front of him. He may be the best player at the table, and he may have people owe him lots of money outside the casino, but if he cannot withstand the ups and downs of the game, he will be out. Similarly, businesses that cannot properly manage their cash positions can end up out of business, even if they generally run a profit.
Cash flow statements provide a detailed picture of how a business manages its cash, both incoming and outgoing, during a specific period. Like the P&L, this is a movie, rather than a snapshot, typically describing what happens over the course of a month or a quarter. Cash flow statements expand on the income section of the P&L by including cash that enters the business from other sources, such as loans that the business received or the sale of assets of the business.
As an example, let’s say that a few years ago you took out a loan of $100,000 to start your practice. You started your third year in business with $50,000 in the bank from last year’s earnings, and in June you see that you now have $124,000 in the bank. So you pay off the loan completely, and after the principal payment clears, there you sit, with $24,000 in the bank.
- Your P&L for the first half shows that you are profitable, having made $94,000 (even though your bank account is $26,000 lighter).
- Your balance sheet is going to show a business with some equity but very little debt.
- Your cash flow statement for the month of June is going to be pretty negative!
As you can see by this example, first, moving around just two variables (loan balances and cash) changes things substantially, and second, a negative cash flow statement isn’t always a bad thing.
Being able to run, read, and explain these reports empowers you to be able to describe the inner workings of your business to others, using language that legitimizes your position.
As variables move throughout the course of a year — and they always do — understanding and running financial reports can help you to sort out and explain exactly what has happened and what is happening in your business.
So…what is the difference between a balance statement and a P&L anyway?!?!
1Stobierski T. “How to Read & Understand a Balance Sheet.” https://online.hbs.edu/blog/post/how-to-read-a-balance-sheet Accessed Oct 21, 2021.
2Stobierski T. “How to Read & Understand a Cash Flow Statement.” https://online.hbs.edu/blog/post/how-to-read-a-cash-flow-statement Accessed Oct 21, 2021.
Ken Erb, PT, is a PPS member and owner of Erb Physical Therapy in Pittsburgh , PA. He can be reached at email@example.com