5 Steps to producing effective practice financial statements

Nov. 1, 2003
Financial statements are an essential practice-management tool. The authors discuss five steps that will help dentists determine their true overhead and profitability quickly and easily.

by Charles Blair, DDS and John McGill, MBA, CPA, JD

Many practice financial statements that present gross collections, operating expenses, and profits are virtually useless. They arrive too late and are so poorly organized that they are incomprehensible to the doctor. Thus, they fail the basic purpose for which they were created — to provide an effective management tool for the doctor. Below are five steps necessary to convert your practice financial statements into a highly effective management tool.

Recently, I reviewed 63 practice financial statements in preparation for a practice-management program that I was presenting. My criteria were simple: could I (as a CPA, MBA, and attorney) determine the doctor's true profitability within one minute of picking up his or her practice financial statement?

Surprisingly, less than 25 percent (15 out of 63) passed the test. Most who failed the test did so miserably. Most listed operating expenses in alphabetical order, rather than in logical category groupings. Other statements were so long, disorganized, and complex that they made Enron's accounting look simple and transparent. Some mixed personal and business expenses; with others, the individual expenses did not add up to the total shown. Those financial statements were an insult to the trees that gave their lives to produce them!

Apparently, a majority of doctors and their advisors have forgotten the purpose of their financial statements: To provide a tool for proper management of the practice. As such, the goal should be to present the practice's financial information in a manner that allows the doctor to determine his or her true overhead (by category) and practice profitability within one minute of picking up the statement. Below are five steps doctors should take to achieve this result.

Group expenses by logical category

Most practice financial statements have various staff compensation expenses (salaries, payroll taxes, fringe benefits, and retirement plan contributions) scattered throughout, making it extremely difficult to determine the doctor's total staff costs without extensive analysis. Our recommended financial statement format* groups all of these expenses together to determine the total staff costs so that it can easily be compared to professional averages for management purposes.

Likewise, we recommend that clinical supply and lab costs be included together under a "Professional Supply and Lab" category that shows both the individual expenses as well as the combined cost numbers. This avoids distortions resulting from misclassification of expenses between supply and lab costs and also provides an easy total to benchmark against professional averages. Furthermore, we recommend that all facility and equipment costs be grouped together under "occupancy" for the same reason.

Separate doctor and staff compensation costs

The worst offenders produced financial statements that lumped all doctor, associate, and staff salaries together and reported them as a single "salaries" figure. Since it is impossible to determine how much of the total salary number is doctor related, how much is associate related, and how much is staff compensation without further inquiry, this format guarantees a completely useless financial statement.

Our recommended format separates doctor and associate compensation costs from staff costs. The staff related costs are shown as a true overhead expense, deducted from practice collections along with all other operating expenses to determine the "Net Income Available for Doctor Compensation." The doctor and associate compensation costs should be deducted as "Doctor Expenses" after the "Net Income Available for Doctor Compensation" has been calculated. This allows the doctor to determine his or her true profit before doctor compensation costs for ease of comparison with other practices.

Likewise, more sophisticated financial statement formats break down staff labor costs between different departments (clerical, chairside, and hygiene) so that these individual totals can then be compared to professional averages to determine if the doctor has a staff overhead problem, and if so, which department(s) are responsible for it.

Show "tax avoidance" expenses "below the line"

We have long recommended that doctors convert as many after-tax personal expenses into legitimate business tax deductions as possible through legal means. Unfortunately, including these expenses as part of normal practice overhead can distort the doctor's true overhead and profitability, making the practice financial statement less than useful.

Since most practices with which we consult report tax avoidance expenses averaging approximately 10 percent of their practice gross collections, this distortion can be substantial. As a result, we recommend that these "tax avoidance" expenses be shown "below the line," after the Net Operating Income Before Doctor's Compensation is calculated. This excludes these items from the normal practice overhead so that the practice's true (adjusted) profitability can be shown. The practice's CPA can later combine these expenses before filing the practice's federal and state income tax returns.

Compare results with industry benchmarks

If the three steps set forth above have been taken, the doctor can easily determine his true practice overhead and profitability. The financial statement should also provide a column showing the percentage of gross collections represented by each operating expense listed, for budgeting purposes.

Doctors can further benefit by measuring these results against some benchmarking standard. Many well-prepared practice financial statements compare the current year practice results against the prior year. Better yet, we recommend that doctors develop an annual practice budget, and then measure their actual results against the budget to measure their success.

Compute variances with standard

Once the benchmarking standard has been set, it is important to see how the current year's results match up. That's why we recommend that practice financial statements provide a column showing the variance between the current year results and the standard selected so that the doctor can easily determine if he or she is ahead or behind the "target." The variances provide a starting point for the doctor to ask "hard questions" about why the practice may not be measuring up to last year's performance, or this year's budget. These questions provide the basis for management changes required in order to improve the practice's performance.

Producing a financial statement that meets its primary objective through the steps set forth above need not be costly or difficult. Many "off the shelf" computer programs (e.g. Quickbooks) can be adapted to generate financial statements that meet these criteria. Most progressive CPA firms can also easily adapt their in-house software programs to achieve these desired results.

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So, give your practice financial statements the "one-minute test." If you can't accurately determine your true practice overhead and related practice profit within that period, it's time for change. Revising your practice financial statements as set forth above will more accurately reflect the practice's true financial performance, but, more importantly, will give you an effective tool to make future management changes to improve profitability.

*For a free copy of our recommended financial statement format, contact our office at (704) 424-9780, or by fax at (704) 424-9785.

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