Financial Statements 2023 PDF

Financial Reports Rajender R. Aparasu, PhD, FAPhA Professor & Chair Department of Pharmaceutical Health Outcomes & Policy University of Houston Learning Objectives • Describe the importance of accounting principles in pharmacy practice • Compare and contrast the fundamental objectives of a balanc...

Financial Reports Rajender R. Aparasu, PhD, FAPhA Professor & Chair Department of Pharmaceutical Health Outcomes & Policy University of Houston Learning Objectives • Describe the importance of accounting principles in pharmacy practice • Compare and contrast the fundamental objectives of a balance sheet and an income statement • Demonstrate the relationship between a balance sheet and an income statement for a given fiscal year • Describe the utility of financial ratios and interpret basic financial ratios used in community pharmacy practice 2 Learning Objectives • Describe and integrate the financial information depicted in a balance sheet and an income statement in community pharmacy practice • Define the flow of funds involved in community pharmacy practice, including expenses, prescription adjudication, receipt of payment, and revenue generation • Describe the basic financial and productivity reports used in hospital pharmacy practice 3 Introduction to Accounting • As math is the language of the physical sciences, accounting is the language of business • It deals with interpreting and communicating info about a company’s operations and finances • It provides the framework for critical decision making • Generally Accepted Accounting Principles (GAAP) serve as the basis for preparing financial reports 4 Three Fundamental Activities • Obtaining financing —acquiring assets from creditors • Making investments —in pharmacy, this is usually acquisition of inventory, equipment, supplies, info systems, dispensing systems, buildings, and land • Conducting a profitable operation —purchasing, distribution, clinical activities, and marketing, among others 5 Primary Financial Statements 1. Balance Sheet or Statement of financial position 2. Income statement or Profit and loss statement 3. Sources and Uses Statement or Cash flow statement 6 6 Balance Sheet or Statement of Financial Position • It shows: • what a business owns (its assets), • what it owes (its liabilities), and • how much is left over (owner equity) • ASSETS = LIABILITIES + OWNER’S EQUITY • Provide data a specific point of time 7 7 Average Top 25% Balance Sheet 8 The Balance Sheet • It provides a snapshot of an organization’s assets, liabilities, and shareholder equity at any particular point in time • The balance sheet is best observed through multiple times (e.g., years) concurrently to observe trends, such as increased liabilities or too much in accounts receivable, which could lead to bad debt, or not enough inventory to generate business output goals 9 Components of Balance Sheet • Assets: are defined as valuable resources that are owned or controlled by the business and were acquired at a measurable cost • Current assets are those that will be sold, consumed, or converted to cash within the current operating cycle of the business (usually 1 year) • Listed on the balance sheet according to liquidity, convertibility into cash 10 10 Current Assets • Common current assets: cash, accounts receivable, inventories, prepaid expenses, and short-term investments • Cash refers to coin, currency, and other items, such as personal checks, charge card receipts, and traveler’s checks, which bank will accept for deposit • Accounts receivable are amounts owed to the pharmacy by its customers as a result of the ordinary extension of credit 11 11 Current Assets • Accounts receivable can be divided into those arising from credit sales and those arising from third parties • Two different types of inventories may appear on the balance sheet: Merchandise inventory & Supplies inventory • Merchandise inventory: consists of goods that the pharmacy has purchased for resale e.g. over-the-counter (OTC) and prescription drugs, cosmetics, and first aid supplies 12 12 Current Assets • Supplies inventory: consists of goods that were purchased for use in the business rather than for resale e.g., prescription labels and vials • Short-term investments investment includes money market accounts, bonds, certificate of deposit. These are converted when cash is needed. 13 13 Other Assets • Prepaid expenses arise from payments made for a good or service in an accounting period prior to the one during which the good or service is actually used • Noncurrent assets are those that under normal conditions are not sold, consumed, or converted to cash within a normal operating cycle of the business, or 1 year 14 14 Other Assets • Examples of fixed assets include and, buildings, fixtures, cars and computers • Also referred to as fixed assets or as fixtures and equipment or long-term assets • Accumulated depreciation is often listed on the balance sheet to provide an estimate of value that is used or lost. 15 15 Liabilities • Liabilities are the business debts which arise from purchasing goods or services on credit or from borrowing money to finance the business’s operations • Classified as current or noncurrent • Current Liabilities: consist of those debts that will come due during the current operating cycle of the business • Example: accounts payable, short-term notes, accrued expenses, and the current portion of long-term debts. 16 16 Account Payable • Accounts payable are debts that arise from purchase of goods or services on credit • Current or short-term payable are debts evidenced by formal, signed agreements called promissory notes • Accrued expenses are amounts owed for goods or services that have been used during the accounting period but for which payment has not been made 17 17 Non-Current Liabilities • The portion of long-term debt that is due the current year is, consequently, a current liability and is called the current portion of long-term debt • Noncurrent liabilities are debts that will come due after the current operating cycle of the business e.g. car loans that are paid off over 5 years • Also be recorded as note payable (long term), mortgage, or long-term debt 18 18 Owner’s Equity • Owner’s equity is the amount left over after liabilities are subtracted from assets • May also be called net worth, stockholders’ equity, or capital • Arises from two sources: Invested capital & Retained earnings • Invested capital consists of cash invested into the business by its owners & it is called common or capital stock 19 19 Owner’s Equity • Transfer from owner’s personal account to the business account is considered an investment in the business • If the cash is withdrawn from the business, it is referred to as owner withdrawals. For a corporation, they are called dividends paid • They decrease invested capital and, consequently, owner equity 20 20 Retained Earnings • Retained earnings are profits (or losses) that the business has made during its years of operation and that have been left in the business • Profits increase retained earnings, while losses decrease them 21 21 The Income Statement • As the balance sheet is only a snapshot, it does not reveal much about what caused these values to change over time • The income statement is a dynamic document providing info about money coming into the organization (revenue/income) and money necessary to obtain that income (expenses). • The difference between the two is net income (or, earnings) • The balance sheet shows retained earnings, which was from the net income from the previous period; other net income went to redistribution to owners (e.g., stock holders), as seen in the statement of retained earnings. 22 Income Statement • • • Also called Profit and Loss Statement Reports the net income of a business for a specific period of time REVENUE – EXPENSES = NET INCOME ➢1. REVENUE – COGS = GROSS MARGIN ➢2. GM– EXPENSES = NET INCOME 23 23 Average Income Statement Top 25% Income Statement Items • Revenues are sales of merchandise normally sold by the business • Prescription sales • Non-prescription sales • Pharmaceutical care service • Cost of Goods Sold is the cost to the seller of all products sold. The figure would be the total of invoice costs to the business less any discounts received • Gross margin is the difference between revenues and cost of goods sold REVENUE – COGS = GROSS MARGIN 25 25 Income Statement Items • Operating Expenses are costs that business incurs to make sales or earn revenues • Examples include salaries, rent, utilities • Depreciation expense is an estimate of the amount of noncurrent assets’ value that has been used up during the current operating cycle – Noncash outlay • Net income also called as net profit or earnings is the difference between gross margin and expenses for a specific period of time 26 26 Statement of Cash Flows • Inflows and outflows of cash throughout the year • Values fall under operating, investing, and financing • It is linked with the other primary financial statements and helps to discern whether cash is being used wisely and is readily available 27 Cash Flow Statement • Also called Sources and Uses Statement or a Statement of changes in financial position • It reflects cash changes during the year or operating period • It shows: • how a pharmacy obtained cash, and • how it used that cash • The largest uses included purchase of noncurrent assets and dividends paid 28 28 Example 29 29 Cash and Accrual Accounting • Cash Methods of Accounting: Revenues are recognized in the period during which cash is received and expenses are recognized in the period during which cash is paid out • Not commonly used by pharmacists 30 30 Accrual Method • Accrual method of accounting: revenues are recognized in the period during which goods are delivered or services rendered • For example: In the same case pharmacy would recognize a revenue in 2022 regardless of when payment was made • Pharmacies usually use accrual method 31 31 Depreciation • Used to allocate the capitalized costs of property, plant, and equipment over the years benefited • It is matching principle – accrual method • Applies to fixed assets, where part of cost is recognized as expense in each year of asset’s life – usage expense • Depreciation: How much expense to allocate each year? 32 Example: Auto-dispense System • Cost (C)= $100,000 • Useful Life (N) = 5 years • Residual Value after Useful life (R)= $0 • Annual depreciation expense (D)? 33 Straight-Line Method • Assumes assets wear out at a constant rate • D = (C-R) / N D = (100,000 – 0) / 5 D = 20,000 • Most often used method 34 Financial Ratios • It is a method of using income statement and balance sheet data to detect trends and problems in the business • It can be used to identify inventory and credit management problems, poor pricing, or declining sales and profitability • Provide information on profitability, liquidity, turnover, solvency and other aspects of business performance. • No single ratio should be used to provide the complete picture. 35 Financial Ratios • Each of these ratios provide different facet of financial analysis • They allow useful comparisons for: • A single organization and the entire industry average • Differences within an organization over time • Two or more organizations with each other (e.g., two chain stores) • Should be compared to a reference point, keep in mind seasons 36 Tests of profitability • Tests of profitability indicate the pharmacy’s ability to cover its expenses plus some excess to reward its owners (profit). Gross Margin Percent: • The gross margin percent (GM %) or Gross Profit % is a measure of the profitability of the pharmacy before operating expenses are considered • NCPA Digest: 23.3% 37 37 Gross Margin Percent: • It is calculated as: GM% = (Sales – COGS) X 100 / Sales Where, COGS = cost of goods sold • It tells the percent of every dollar of sales that is available to cover operating expenses and profit • Pharmacies earn higher gross margins when they charge higher prices or buy merchandise less expensively (costs). 38 38 Gross Margins Across Supply Chain* • • • • Manufacturer 71% Wholesaler 4% PBM 6% All Pharmacies 20% • Brand 4% • Generics 43% 39 * UCLA Analyses: US sales-weighted averages based on data from 2015 SEC 10K filings and annual reports 39 Net Income Percent • The NI% is also referred to as the net profit margin. • It is a measure of profitability after expenses are considered. • It is sensitive to product mix, prescription volume, and type of payers • The net income percent is calculated as: NI % = Net Income X 100% / Sales • NCPA Digest: 2.2% 40 40 Net Income Percent • The net income percent may be increased by increasing the gross margin percent • Raising prices or Increasing quantity sold • Purchasing goods at lower cost • Decreasing expenses – focus on big tickets • NI% can be calculated with net income before taxes or net income after taxes • NCPA digest numbers are before tax 41 41 Net Profit Across Supply Chain* • • • • Manufacturer 26.3% Wholesaler 0.5% PBM 2.3% All Pharmacies 4% 42 * UCLA Analyses: US sales-weighted averages based on data from 2015 SEC 10K filings and annual reports 42 Return on Equity (ROE) • This measure is oriented toward investors. • It indicates the rate of return they would, or did, earn by investing in the business. • The ROE is calculated as: ROE = Net income X 100% / Owner’s equity • As with net income percent, ROE can be calculated with net income before taxes or net income after taxes • NCPA Digest: 17.9% 43 43 Return on Equity (ROE) • ROE can be improved in two ways: • Increasing the pharmacy’s net income • volume of sales • raising prices • lowering expenses • Decreasing owner’s equity • More debt and less owner investment • Owner can borrow more of the funds and use less capital - known as financial leverage - but it is also risky 44 44 Return on Equity (ROE) • Pharmacies can have high financial leverage when there is too much debt and little owner investment. • Financial crisis occurs: • Losing a major source of revenue • Pay a large and unanticipated expense • Pay the loan back • Cash flow problems • ROE is usually higher for new pharmacies and lower for older pharmacies 45 45 Return on Assets (ROA) • This ratio measures how effectively all funds available to the manager, both debt and equity, have been used. • ROA is a better indicator of a manager’s performance than ROE because it considers all funds at the manager’s disposal, not just invested funds. • ROA is calculated as: ROA = Net income X 100% / Total assets 46 46 Tests of Liquidity • Tests of liquidity measure the firm’s ability to pay its current debt as it comes due 1. Current Ratio (CR): • The CR compares a pharmacy’s current assets, which supply the cash to pay current debt, with its current debt • Creditors, such as bankers or wholesalers, are interested in this ratio, because it measures the pharmacy’s ability to repay them on time 47 47 Current Ratio (CR) The CR can be calculated as: CR = Current assets / Current liabilities • Creditors prefer high CR, i.e. high proportion of current assets to current debt. • A rule of thumb suggests that the CR should be between 2 and 4. • A lower ratio indicates that the pharmacy may have problems paying current debts on time. • 48 48 Current Ratio (CR) • A ratio greater than 5 suggests that the pharmacy has too much invested in current assets. • more current assets than needed is inefficient • negative effect on return on equity and assets • NCPA Digest: 3.4 49 49 Quick Ratio (QR) • The QR or acid test is similar to the current ratio but is a more stringent test of the firm’s liquidity. • It can be calculated as: QR = (Current assets – inventory) Current liabilities • The QR measures the excess of very liquid current assets – cash and accounts receivable – to current liabilities. 50 50 Quick Ratio • The rule of thumb indicates that the quick ratio should be between 1 and 2. • Pharmacies can operate with lower quick ratios than other business • Major current asset is inventory • Merchandise sells quickly • NCPA Digest: 1.53 51 51 Turnover Ratios Accounts Receivable Turnover (ART) • The ART is an estimate of the average number of days it takes the pharmacy to collect an account receivable • It estimates the average number of days between when a charge sale is made and when payment for the sale is collected • The ARCP can be calculated as: ARCP = Accounts receivable Net credit sales per day* 52 52 Accounts Receivable Turnover • Net credit sales per day= Total sales x Credit Sales% 365 • The rule of thumb states that the ART should be no greater than 1.5 times the firm’s credit terms • Longer periods indicate poor collection • Bad credit management policies • Bad insurance companies or PBMs • NCPA Digest: 15 days 53 53 Accounts Receivable Turnover • Most prescription sales in community pharmacies are credit sales • paid for by third parties such as insurance companies, HMOs, or state Medicaid agencies • Most community pharmacies have some amount of cash prescription sales • Uninsured • Deductibles • Medicare Donut hole • $ 4 or $ 6 prescription 54 54 Inventory Turnover (ITO) • ITO measures the rate of movement of inventory • It indicates how quickly purchased inventory is sold • ITO is calculated as: ITO = COGS / Average inventory at cost • Average inventory is calculated using inventory levels at the beginning and end of the year 55 55 Inventory Turnover (ITO) • It can be calculated from the available information using the following formula • COGS = BI + P – EI Where, COGS = Cost of the Goods Sold BI = Beginning inventory EI = Ending inventory • Inventory Turnover (ITO): COGS (BI+EI)/2 56 56 Inventory Turnover • A high turnover is desirable • ROA and ROE will be maximized • Pharmacy may frequently find itself out of stock • Inventory turnover may be increased by: • Increasing sales without increasing inventory or • Decreasing inventory with the same sales volume • NCPA Digest: 11.1 (ITO) • NCPA Digest : 33 days (ITO days) • NCPA Digest: 12.0 (RX ITO) • NCPA Digest : 30 days (RX ITO days) 57 57 Factors to Consider with Inventory Management • Selection of generic products —look for reputable manufacturers but with good prices • Reduction of inventory size —to create space for goods with high margins which complement your business mission, goals, and services • Management of unclaimed prescriptions —keep this in mind in developing your inventory, as prescription drugs not claimed • Use of formularies —can lower costs if a pharmacy (usually hospital) carries only a limited number of products 58 Specialty Pharmacy • Drug and biologic products with high costs or present reimbursement challenges • Cancer, HIV, Multiple sclerosis, Rheumatoid arthritis, Hemophilia, Psoriasis, Crohn's Colitis Disease, Immune deficiencies, etc. • Special handling or storage requirements or require administration at time of dispensing • As such, pharmacies might limit their inventory of specialty products 59 Role of Technology • Computer systems in inventory management can integrate data on goods in stock, information, and costs • Purchase-trend report—describes the quantity purchased of OTC products or Rx products by month or by quarter • Sales-analysis report—features a rolling 12-month statement that includes order qty, shipped qty, unavailable qty, returns, credits, and dollars spent • Item-movement report —lists which items are selling the best 60 Role of Technology • Web-based systems interact real-time with wholesalers to view available quantity • e-procurement allows for immediate item allocation and order confirmation • Radiofrequency identification (RFID)—microchips to improve distribution from manufacturer to wholesaler to pharmacy 61 Asset Turnover (ATO) • ATO measures how efficiently the pharmacies total assets are used • Ratio shows how many sales are produced by one dollar of assets • ATO is calculated by dividing the pharmacy’s sales for the year by its total assets • ATO can be calculated as: ATO = Sales / Total Assets 62 62 Asset Turnover • A high ATO is desirable. • Also results in higher rates of ROE and ROA. • ATO can be improved by: • Increasing sales while holding asset investment • Decreasing asset investment while increasing or maintaining sales • NCPA Digest: 4.4 63 63 Solvency Tests • Solvency ratios measure a business’s ability to meet its long-term debt payments • They are also called debt-to-equity ratios because they compare the amount borrowed to the amount invested • Debt refers to funds that have been lent to the business • Repaid according to a set schedule • Legally obligated to pay its debts on time • risky method of raising funds 64 64 Debt-to-Equity • Debt confers no ownership of the business to the lender • If the business does well, the owner is required only to repay the debt and interest • Equity refers to funds that have been invested in the business. • Does not have to be repaid • Gives the investor ownership 65 65 Debt-to-Equity • Lenders, such as bankers, prefer that pharmacies have low debt-to-equity ratios • Owners have more invested in the business • Owners have a strong incentive to do well 66 66 Solvency Ratios Total debt to owner equity = Total debt x 100% Owner equity • This ratio is the most direct measure of a firm's financial position • It measures the firm's ability to withstand adversity • NCPA Digest: 42% 67 67 Financial Reports in Community Pharmacy Practice • A plan payment report helps the manager monitor the daily number of prescriptions paid by third-party payers, cash/copayments from customers, & total costs of drug products • Daily inspection informs the manager of those payers with low rates • Also helps inform manager if pharmacy has received best prices from wholesalers • Manager must revise numbers, as the actual amount paid will likely be less than what is evident in the plan payment report 68 Financial Reports in Hospital Pharmacy Practice • • • • Budget is primarily comprised of drug costs and labor Is a part of the global budget for the entire hospital Whereas community pharmacies are typically profit centers Can increase profitability by selling more goods and providing more services • Hospital pharmacy departments are cost centers • Don’t generate revenue directly; contribute by lowering overall cost 69 Financial Reports in Hospital Pharmacy Practice • Use of Expense Report • Consolidates the expenses for the month and compares actual expenses against budgeted expenses • All pharmacy department expenses are categorized • Each expense is given a unique code • Expense report indicates: • Amount budgeted for each expense • Actual expense incurred • Variance and variance percentage to find outliers; categories with a positive value for variance indicate that the department has spent more money than it had budgeted for that category 70 Hospital Pharmacy Productivity Assessment • Demonstrates the number of full-time equivalent (FTE) employees and the quantity of outputs (medication orders, clinical services) • Useful to track historical data • Helps to determine optimal number of employees in a given pay period, and for a total year, as well as evaluate overtime pay • Other productivity ratios in hospital pharmacy examine patient days, drug cost per patient day, and labor cost per patient day 71 Hospital Pharmacy Ratios • These ratios compare usage of inventory or personnel to measures of workload such as prescriptions dispensed or patient days • Annual Patient Days is based on number of patient treated and length of stay • 1 patient hospitalized for 5 days - 5 patient days • 10 patients hospitalized for 5 days - 50 patient days 72 72 Personal Expense per Patient Day • The efficiency with which personnel are utilized is measured by the personnel expense per patient day ratio • Personal Expense per Patient Day = Total annual pharmacy payroll Annual patient days 73 73 Drug Expense per Patient Day • The efficiency with which pharmaceutical expenditures are managed is measured by the drug expense per patient day ratio. • Drug expense per patient day = Total annual drug expense Annual patient days. 74 74 Interpreting Financial Ratios • There are two commonly used standards Internal Benchmarking • Comparison of the present year’s ratios with those for past years identifies trends • This indicates whether the pharmacy’s financial performance is improving or deteriorating 75 75 Interpreting Financial Ratios External Benchmarking • Ratios of other pharmacies of the same type and with similar financial resources. • Many professional organizations provide financial information and ratios through periodic surveys of their membership • Ratios for independently owned community pharmacies may be found in the NCPA Digest • Problems arise when pharmacies differ in prescription volume, location, and accounting 76 76 Cautions for Financial Ratios • Ratio analysis is a diagnostic tool • Analysis will identify pharmacy’s problems and their probable causes • It does not provide information about how to solve the problems • A ratio analysis yields suggestive, rather than definitive answers • Managers must use caution in interpreting the results of a ratio analysis 77 77 Cautions for Financial Ratios • A proper and correct interpretation requires use of other data, such as particular policies, peculiarities, and practices of the pharmacy • Ratios are based on balance sheet and income statement data • Assets are listed at their historical/book value • Income statement values can modified to show better numbers – depreciation expense 78 78 Summary • Accounting helps the business make financial, and thus other types of decisions to ensure efficiency and profitability • The three most important and frequently utilized financial statements are the balance sheet, income statement, and statement of cash flows • The balance sheet provides a snapshot of assets, liabilities, and owner’s equity • The income statement provides for a certain period the income and expenses used to generate that income 79 Summary • The statement of cash flows helps managers to maintain and prepare for adequate amounts of cash needed to run the business • Profitability, liquidity, and turnover ratios help managers determine efficiency in generating profits from assets, the proper amount of cash to pay short-term bills, and the proper inventory and accounts receivable to maintain • These ratios should be compared against industry averages and recommendations • Hospital pharmacies use these and productivity ratios to determine the appropriateness of labor capital to run the department; a hospital’s pharmacy department is not viewed not as a profit center, but as a cost center 80 Class Problem Using the following information, prepare complete income statement and balance sheet. Current liability Sales Total expenses Long-term Liability 40,000 Current assets 80,000 120,000 Cost of goods sold 70,000 30,000 Fixed and other Assets 20,000 10,000 • First classify – Balance or Income • Second - List the account/amount appropriately 81 Balance Sheet ASSETS Current Assets Fixed Assets 80,000 20,000 Total Assets LIABILITIES Current Liabilities Long-term Liabilities 100,000 40,000 10,000 Total Liabilities 50,000 OWNER’S EQUITY 50,000 82 Income Statement Sales Cost of Goods Sold Gross Margin 120,000 70,000 50,000 Total Expenses Net Income 30,000 20,000 83 Thank You 84