Your Hospital's Financial Statements: How Management Keeps Score

Part I: The Income Statement

 

If any of you have heard me speak, you know how strongly I feel that physicians need to understand how to read financial statements. Paradoxically, many of you manage large and complex practices and physician leaders often sit at the governing board listening to financial reports, and yet, most of you have never been exposed to formal training on how to read and interpret financial statements. Furthermore, our medical schools considered it inappropriate to provide this training even though the practice of medicine, while a noble healing art and science, is also a business that requires financial and managerial skills. Today, it is even more imperative for physicians to train themselves to speak “management’s language” as they assume a growing role in not only overseeing the quality of care that their patients receive, but also the operational efficiency and financial performance of that care as well.

 

As an introduction to the concepts of reading and interpreting financial statements, I will present a three-part series covering each of the financial statements your hospital uses to track its financial performance:

• The income statement

• The balance sheet 

• The statement of cash flows

 

First, some words of introduction regarding accounting in general. During the great depression, many businesses and industries failed, bringing down the entire securities industry. As a result, the federal government realized the only way to protect the public and investors was to require a set of financial statements that were easy to interpret and would enable interested parties to make informed decisions. This decision created the field of financial accounting to set standards for the reporting of financial information by businesses to external parties, such as the federal government, the IRS, investors, creditors, and the public at large.

 

The three financial statements your hospital utilizes are required by the Securities and Exchange Commission (SEC), an independent regulatory agency of the government that is given authority to oversee and enforce the form and content of financial statements. The SEC, in turn, delegates the authority for developing standards for financial statements to the Financial Accounting Standards Board, which, in turn, delegates industry specific standards to the American Institute of Certified Public Accountants, which establishes the standards required for financial statements within the healthcare industry. The guidelines promulgated by these three organizations make up what are called generally accepted accounting principles (GAAP).

 

Every year, your hospital is required by the federal government to submit its financial statements to an external auditor (usually a large accounting firm) to ensure financial statements conform to GAAP. If all is well, the auditors will give an unqualified opinion. If there are some issues, they will give a qualified opinion. And if there are significant issues, they will give an adverse opinion.

 

The financial statements your hospital uses cover a specified amount of time called an accounting period. Sometimes, that period coincides with the calendar year and sometimes it does not and is called a fiscal year. A good practice is to end the accounting period when business is at a slower pace so the accounting statements will more accurately reflect the financial activity of the organization.

 

There are two types of accounting methods:

• Cash

• Accrual

 

Under cash accounting, economic events are recognized when a financial transaction occurs. This is the most common type of accounting in an office-based practice, where the policy generally is to request payment at the time of service. Hospitals, however, typically use the accrual accounting system because the economic events are recognized when a service is provided that creates a payment obligation and not when a financial transaction occurs.

 

The income statement (also called the statement of operations, statement of activities, or the profit and loss statement) is the first financial statement to consider and is the simplest. Its purpose is to answer the question as to whether the hospital is profitable. It reports all of the operating revenue (revenue generated by patient services), the non-operating revenue (revenue generated by non-patient activities such as investments, the gift shop, cafeteria, etc.), the operating expenses, and non-operating expenses to come up with the difference between the total revenues and the total expenses which determines net income or profit of the organization. If the organization loses money, the net income is reported in parentheses.  For example, ($250,000) represents a net loss of $250,000. Thus, the income statement represents the simple formula:

 

                 Revenues – Expenses = Net income

 

The first line on an income statement is typically gross operating revenues. This figure represents the total amount of charges for patient care services. As you know all too well, that figure does not represent what is collected, which is the net operating revenue. The difference between the two is typically called “deductions from revenue” which represents contractual deductions by third party payers, charity care, and bad debt. GAAP requires charity care (charges you don’t expect to get paid) and bad debt (charges you expect to get paid) be handled differently. Bad debt is considered an operating expense, whereas charity care is considered a foot note at the bottom of the income statement and cannot be tallied as an expense.

 

The second item is non-operating revenues which include revenues from any source other than patient care services. Such revenues may come from:

• Investments,

• Endowments,

• Gift shop,

• Cafeteria

 

 Net operating and non-operating revenues are combined to create the total revenue. Operating expenses generally include:

• Salaries and benefits (typically makes up more than half of the hospital’s total expenses),

• Supplies

• Insurance

 

Non-operating expenses include:

• Leases

• Provision for bad debt (as mentioned above)

• Interest

• Depreciation

 

Depreciation is a significant cost for hospitals and other healthcare organizations. Hospitals have very high fixed costs, which are the investments made before revenue is generated.  Fixed costs include:

• Buildings and grounds

• Utilities

• Diagnostic and therapeutic equipment

 

GAAP requires the value of these fixed costs be expensed over time to designate that each asset has a pre-determined period of useful activity. For instance, a CT scanner that costs $1.5 million typically has a predicted life of 10 years. If the straight line depreciation method is utilized (allocating an equal amount of expense each year), the book value of this asset would decline or depreciate $150,000/year. Thus, the CT scanner would be worth $1.5 million dollars in year one, $1.35 million dollars in year two, $1.2 million dollars in year three, etc. until it would lose all of its value by year 10. Depreciation is a significant expense and will show up again on the balance statement as accumulated depreciation representing the total amount of value that fixed assets have lost over a defined period of time.

 

Operating and non-operating expenses are then added together to make total expenses, which are subtracted from total revenues to reveal the net income as a profit or loss. Finally, at the bottom of the income statement will be one of two values:

• Net assets (nonprofit organization)

• Retained earnings (for-profit organization)

 

Both of these values represent the equity or value of the organization once the total liabilities are deducted from the total assets. For-profit entities can raise capital by selling stock on the securities market, whereas nonprofit entities must either rely on endowments /donations or the sale of tax exempt bonds on the bond market. The net value of an organization after it deducts all of the funds owed to creditors and investors is considered its equity or net asset. The net assets (or retained earnings in for-profit entities) at the beginning of the year are often listed at the bottom of the income statement. To this, you add the net income (or loss) to get the net assets or retained earnings at the end of the year. This figure can either be a positive or negative number depending on whether the organization has increased in value or lost its net value.

 

A typical income statement would look like this:

 

                                                                                      This year                Last year

 

Revenues:

Net operating revenue

Net non-operating revenue

        Total revenues:

 

Expenses:

Operating expenses

Salaries and benefits

Supplies

Insurance

Lease (e.g. CT scanner)

Non-operating expenses

Depreciation

Provision for bad debts

Interest

        Total expenses

 

Net income     (total revenues – total expenses)

 

Under GAAP, net income measures profitability (or lack thereof) and is a key indicator of the ability of the organization to be profitable. Unfortunately, because of accrual accounting, the income statement does not tell the whole story and it is theoretically possible for an organization to show a healthy profit on its income statement and be extremely cash poor as revenues do not necessarily connote payment for those services. The income statement should be considered an important piece in the puzzle, but does not represent an organization’s total financial well being and other financial statements and indicators are necessary.

 

Next time, I will cover the balance sheet, which, unlike the income statement, provides a snapshot of an organization’s financial viability at a specific moment in time.

 

 

 

Jon Burroughs, MD, MBA, FACPE, is a senior consultant and director of education services with The Greeley Company, a division of HCPro, Inc.