corporations, small businesses, and even individuals
determine and report how they finance their activities and use their money. A major use of accounting is to track the flow of money (cash or credit) between financing and investing activities. Understanding financial reports is essential to understanding the flow of money. Financial reports are prepared based on standard accounting principles. Assets are things that a business owns that can be used to generate income (e.g., driving paying passengers to their destinations in your cab). Obtaining the money needed to acquire an asset requires financing. These sources of financing can be further classified as liabilities (money owed to others) and owner’s equity (the owner’s own funds). Whatever the total amount invested in an asset, it always must equal the amount financed for its acquisition. This brings us to the most important rule in accounting, often referred to as the accounting equation: Assets = owner’s equity + liabilities Accounting principles are essential tools that can be applied in all areas of pharmacy practice (Stickney, 1999). This is so because any pharmacy, just as any other type of organization, engages in three fundamental activities: - Obtaining financing - Making investments - Conducting a profitable operation To start a business, one needs to acquire assets. Financing activities to acquire assets involve obtaining funds from owners and creditors (i.e., banks). When owners fund the activities of a corporation, they become shareholders of the corporation. Shareholders have a claim on the company’s assets, and their investments in the company are rewarded by either regular distributions from the company to the owners (also known as dividends) or by an increase in the value of company’s total assets owing to profitable operations. Creditors, on the other hand, provide funds to the company but do not receive dividends. They require the company to repay the funds with interest over a specified period of time. The types of investments a company makes depend largely on the type of business it is conducting. In pharmacy settings, funds are invested in acquisition of inventory, computer software and hardware, robotics, buildings, and land. Generally, the operating activities of pharmacy settings include purchasing, distribution (i.e., prescription- filling activities), clinical activities, and administration. In many pharmacies, marketing is also a significant operation activity, in that it is required so that others can learn of the goods and services that the pharmacy offers. The balance sheet provides a snapshot of an organization’s assets, liabilities, and shareholder equity at any particular point in time. The income statement is a dynamic document that provides information about money coming into an organization (income) and money necessary to obtain that income (expenses). The difference between income and expenses is commonly referred to as net income, net profit, or earnings. The income statement tells the reader what happens to an organization over a period of time. Throughout the fiscal year, the inflows and outflows of cash are recorded in the statement of cash flows. Organizations, investors, creditors, and even individuals use financial ratios to examine an organization’s financial performance. Since an inherent goal of any business is to be profitable, we can view profitability ratios as measures of overall success in the daily operations of a business. More specifically, profitability ratios provide a method to measure the overall financial success of a company. Examining profitability ratios allows managers to assess the company’s level of success in generating profits. The most commonly used profitability ratios are the gross profit margin and the net profit margin. Gross profit margin = (sales − cost of goods sold) ÷ total sales
By considering the cost of goods sold, this ratio
provides information on the company’s ability to generate gross profits. Higher gross profit margin ratios are desirable because they indicate the availability of funds for the company’s other expenses. Net profit margin = net income (after taxes) ÷ total sales
Net profit margin indicates the fraction of net profit
that is generated for every dollar of sales. As mentioned earlier, as a profitability ratio, it could be used to determine how well the organization manages its operating expenses. It could also be used to compare the performance of two or more pharmacies within a chain or to assess the performance of a pharmacy against industry averages. Return on assets (ROA) = net income ÷ average total assets
This ratio provides information on the company’s
ability to generate profits using the company’s assets. As stated in the introduction, profits can only be generated from the company’s assets. Therefore, effective use of assets results in a high ROA ratio. Return on equity (ROE) = net income ÷ average owner’s equity
Return on equity, also known as return on investment
(ROI), is a measure of how well the company can make profits from funds provided by owners or investors. High ROE levels are desirable because investors— similar to companies—are interested in maximizing their profits. ROA and ROE sometimes are used to gauge the manager’s performance. All else equal, managers who make better financial decisions are better able to produce higher ROA and ROE ratios for their organizations. Liquidity ratios provide information on the business’s ability to meet its short-term financial obligations. The most popular liquidity ratios are the current ratio and the quick ratio. The current ratio is the ratio of current assets to current liabilities. Current ratio = current assets ÷ current liabilities An organization with a high current ratio is taking fewer risks in meeting its financial obligations. For example, having a lot of cash in the bank and few debts (liabilities) to pay results in a high value for current assets, a low value for liabilities, and therefore a high current ratio. An alternative to the current ratio is the quick ratio (also known as the acid test). For this ratio, quick assets are defined as assets that are easily converted to cash. Therefore, inventories and prepaid expenses (such as prepaid rent and insurance policies) are not included in calculating assets. Because the quick ratio considers only assets that are easily converted to cash (and therefore can be used to pay bills, etc.), it provides a better picture of a company’s liquidity and its ability to meet its financial obligations. Quick ratio = (current assets − inventories − prepaid expenses) ÷ current liabilities Turnover ratios measure the efficiency with which an organization uses its assets. They are also referred to as efficiency ratios or asset utilization ratios. The two most commonly used turnover ratios are inventory turnover and receivables turnover. Inventory turnover ratio = cost of goods sold ÷ average inventory (at cost)
The inventory turnover ratio measures how quickly, on
average, an organization’s inventories are sold. The data for this ratio come from two different financial statements. Cost of goods sold (COGS) is found on the income statement, and the average inventory comes from the balance sheet. Receivables turnover ratio = credit sales ÷ average accounts receivable
This ratio measures how quickly receivables (money owed
to the organization by others) are turned into cash. A high receivable turnover ratio shows that the organization can collect its receivables efficiently while keeping the total amount it is owed by others at any given time relatively low. If you divide the receivable turnover ratio by 365, you will have a ratio known as the average collection period. The average collection period indicates the number of days (on average) that credit sales remain in accounts receivable before they are collected. Financial reports used in independent pharmacy practice are very similar to those used in chain community pharmacies. Managers in chain community pharmacies pay attention to the same financial ratios and key indicators on balance sheets and income statements. Financial reports used to manage the department of pharmacy in hospitals are often quite different from those used in community pharmacy practice. The budget for a hospital pharmacy department consists primarily of drug costs and labor (i.e., pharmacists, technicians, and administrators) and is a part of the global budget of the entire hospital. Drug costs are generally the larger of the two components, although this varies with the size of the hospital, the size of the pharmacy department, and the types of clinical and administrative services the hospital provides. A third party is defined as an organization that reimburses a pharmacy or patient for all or part of the patient’s prescription drug costs. Since most prescriptions dispensed in pharmacies today are paid for by third parties, it is essential that pharmacy managers and pharmacists understand the effect of third parties on pharmacy operations. Pharmacies have third-party patients and private pay patients. Private-pay patients, sometimes referred to as cash patients, are people who do not have any health insurance coverage or people who have health insurance that does not cover prescription drugs. From the pharmacy’s perspective, patients who pay the pharmacy directly for their prescriptions and later are reimbursed by their insurance company often are indistinguishable from private-pay patients. This type of prescription drug insurance, called indemnity insurance, used to be common, but it now has been replaced largely by service benefit plans. Under a service benefit plan, the patient may pay the pharmacy a predetermined portion of the prescription cost, but the pharmacy is reimbursed directly by the third party for most of the prescription cost. Third parties may be public or private. Private third parties typically are insurance companies, although other private entities sometimes pay for a patient’s prescriptions. The reimbursement rate, or price, for a third-party prescription is based on a reimbursement-rate formula that is specified in the contract between the pharmacy and the third-party payer. The reimbursement-rate formula almost universally consists of two parts: the product cost portion and the dispensing fee. The product cost portion is intended to pay the pharmacy for the cost of the drug product, and the dispensing fee is intended to cover the cost of dispensing the prescription. The total reimbursement rate (product cost + dispensing fee) should be higher than the costs of obtaining and dispensing the drug to provide some profit to the pharmacy. Costs can be separated into two different types of costs: fixed and variable. Fixed costs are costs that do not change as prescription volume changes (e.g., rent, pharmacy license, and depreciation). A variation is semifixed costs, which only change with large changes in prescription volume. An example of a semifixed cost would be pharmacist labor costs. Pharmacists will not be hired or fired for small changes in prescription volume, but if there are large changes in prescription volume, it may be necessary to change the number of pharmacists employed by the pharmacy or reduce pharmacist hours (e.g., full time to part time). Variable costs are costs that change directly as prescription volume changes (e.g., prescription vials). When differential analysis is discussed, it will be necessary to identify the average variable costs of dispensing a prescription. Another way to classify costs is direct versus indirect. Direct costs are costs that are completely attributable to the prescription department (e.g., the costs of prescription vials and the prescription department computer). Pharmacist labor is considered a direct expense unless the pharmacist has managerial responsibilities in nonprescription departments. Indirect costs are costs that are shared between the prescription department and the rest of the store. Rent, clerical labor costs, utilities, and advertising for the pharmacy are examples of indirect expenses. Step 1: Identify costs associated with the prescription department. Step 2: Sum all the prescription department costs. Step 3: Divide the prescription expenses by the number of prescriptions dispensed. Medicare Part D is a voluntary prescription drug insurance plan administered by numerous health plans and offered to all Medicare enrolees. A budget is a detailed plan, expressed in quantitative terms, that specifies how resources will be acquired and used during a specified period of time. The procedures used to develop a budget constitute a budgeting system. Budgeting systems have five primary purposes. The most obvious purpose of a budget is to quantify a plan of action. The budgeting process forces people who make up an organization to anticipate or react to changes in the environment. For any organization to be effective, each manager throughout the organization must be aware of plans made by other managers. The budgeting process pulls together the plans of each manager in an organization. Any organization’s resources are limited, including pharmacies and pharmacy departments. Budgets provide one means of allocating resources among competing uses. Hospitals, for example, must make difficult decisions about allocating their revenue among services (e.g., pharmacy, laboratory, and nursing), maintenance of property and equipment (e.g., beds, laminar flow hoods, and vehicles), and other community services (e.g., child care services and programs to prevent alcohol and drug abuse). In particular, allocating resources to pharmacy initiatives to improve patient safety as a result of drug-related deaths has had to compete with other areas where dollars are also needed to improve patient care (Tierney, 2004). A budget is a plan, and plans are subject to change. A budget serves as a useful benchmark with which actual results can be compared. For example, a pharmacy business can compare its actual sales of prescriptions for a year against its budgeted sales. Such comparisons can help managers evaluate the pharmacy’s effectiveness in selling prescriptions. Nevertheless, pharmacy managers must be prepared for a financial crisis. Taking the initiative to acquire appropriate data, to translate those data into relevant information, and to seek benchmarks for comparison is important. Once the crisis has passed, attention must be given to updating and maintaining databases, supporting the staff, and improving morale. Scenario planning can help to identify measures that might be taken if another crisis should develop (Demers, 2001). Comparing actual results with budgeted results also helps pharmacy managers evaluate the performance of individuals, departments, or entire corporations. Since budgets are used to evaluate performance, they can also be used to provide incentives for people to perform well. Many health care organizations are beginning to implement pay-for-performance (P4P) programs that will tie monetary incentives for pharmacy personnel to hospital quality scores (Gregg, Moscovice, and Remus, 2006). A master budget, or profit plan, is a comprehensive set of budgets covering all phases of a pharmacy organization’s operations for a specified period of time. Budgeted financial statements, often called pro forma financial statements, show how the pharmacy organization’s financial statements will appear at a specified time if operations proceed according to plan. Budgeted financial statements include a budgeted income statement, a budgeted balance sheet, and a budgeted statement of cash flows. A capital budget is a plan for the acquisition of capital assets, such as buildings and equipment. A financial budget is a plan that shows how the pharmacy business will acquire its financial resources, such as through the issuance of stock or incurrence of debt. Budgets are developed for specific time periods. Short- range budgets cover a year, a quarter, or a month, whereas long-range budgets cover periods longer than a year. Rolling budgets are continually updated by periodically adding a new incremental time period, such as a quarter, and dropping the period just completed. Rolling budgets are also called revolving budgets or continuous budgets. The master budget, the principal output of a budgeting system, is a comprehensive profit plan that ties together all phases of a pharmacy’s operations. The master budget consists of many separate budgets, or schedules, that are interdependent. The starting point for any master budget is a sales revenue budget. For many pharmacy departments, this budget begins with a sales forecast for prescription drug spending. A pharmacy manager would need to keep abreast of how changes in government expenditures (e.g., Medicare prescription drug coverage) might change the distribution of drug spending among payers and affect aggregate spending (Poisal et al., 2007). All pharmacies have two things in common when it comes to forecasting sales of services or goods. Sales forecasting is a critical step in the budgeting process, and it is very difficult to do accurately. Various procedures are used in sales forecasting, and the final forecast usually combines information from many different sources. Many pharmacy corporations have a market research staff whose job is to coordinate the corporation’s sales forecasting efforts. Typically, everyone from key executives to the firm’s sales personnel will be asked to contribute sales projections. Based on the sales budget, a pharmacy organization develops a set of operational budgets that specify how its operations will be carried out to meet the demand for its goods or services. The final portion of the master budget includes a budgeted income statement, a budgeted balance sheet, and a budgeted statement of cash flows. These budgeted financial statements show the overall financial results of the pharmacy organization’s planned operations for the budget period. The master budget for a nonprofit organization includes many of the components. However, there are some important differences. Many nonprofit organizations provide services free of charge. Hence there is no sales budget. However, such organizations do begin their budgeting process with a budget that shows the level of services to be provided. For example, the budget for a free clinic would show the planned levels of various public services, such as the hours of operation for the outpatient pharmacy. Nonprofit organizations also prepare budgets showing their anticipated funding. A free clinic budgets for revenue from both public (e.g., support from government agencies) and private sources (e.g., donations). ABC uses a two-stage cost assignment process. In stage 1, overhead costs are assigned to cost pools that represent the most significant activities. The activities identified vary across pharmacy organizations, but examples include such activities as purchasing, materials handling, prescription processing, scheduling, inspection, quality control, purchasing, and inventory control. After assigning costs to the activity cost pools in stage 1, cost drivers are identified that are appropriate for each cost pool. Then, in stage 2, the overhead costs are allocated from each activity cost pool to cost objects (e.g., prescriptions, value-added services, and patients) in proportion to the amount of activity consumed. Under ABB, the first step is to specify the products or services to be produced and the customers to be served. Then the activities that are necessary to produce these products and services are determined. Finally, the resources necessary to perform the specified activities are quantified. A financial planning model is a set of mathematical relationships that expresses the interactions among the various operational, financial, and environmental events that determine the overall results of an organization’s activities. A financial planning model is a mathematical expression of all the relationships. Budget director or chief budget officer – this is often the organization’s controller (or comptroller in government organizations). The budget director specifies the process by which budget data will be gathered, collects the information, and prepares the master budget. Budget manual – states who is responsible for providing various types of information, when the information is required, and what form the information is to take. e-Budgeting is an increasingly popular Internet-based budgeting tool that can help to streamline and speed up an organization’s budgeting process. The e in e- budgeting stands for both electronic and enterprise- wide. Employees throughout an organization and at all levels can submit and retrieve budget information electronically via the Internet. Zero-base budgeting is used in a wide variety of organizations. Under zero-base budgeting, the budget for virtually every activity in the organization is initially set to zero. To receive funding during the budgeting process, each activity must be justified in terms of its continued usefulness. The zero-base- budgeting approach forces management to rethink each phase of an organization’s operations before allocating resources. THE FINANCIAL PLANNING PROCESS Personal financial planning is the process of managing one’s money to achieve economic satisfaction (Kapoor, Dlabay, and Hughes, 2004). The primary purpose of this process is to allow one to control one’s financial situation by identifying and developing a plan to meet specific needs and goals. The first step requires that one assess one’s current situation regarding income, savings, living expenses, and debts. This step requires that one prepare a list of current asset and debt balances, along with present expenditures. Personal finance statements can be a useful tool for this step. The purpose of this step is to differentiate a person’s needs from his or her wants. This analysis involves identifying how one feels about money. Are feelings based on objective information? Are priorities based on social pressures, needs, or desires? It is important to understand that while wants are unlimited, resources are limited. People should set their financial priorities around satisfying needs (e.g., food, clothing, shelter, and transportation) before considering to what extent their wants can be satisfied. Many factors influence potential alternative courses of action. Considering all possible alternatives helps people to make more effective financial decisions. The most common categories include: Continuing along the same course of action. For example, one might decide that saving 5 percent of one’s gross income is adequate for one’s financial goals. Expanding the current situation. Alternatively, one might decide that 10 percent of one’s salary is a more appropriate amount to save to meet important goals. Changing the current situation. One might decide that aggressive stock investments are too risky given the stock market environment. Therefore, a more conservative investment approach is warranted. Taking a new course of action. Some people may decide that instead of investing their monthly savings, they will divert it toward paying off debts such as student loans. People need to evaluate from among their possible courses of action. Life situation, personal values, current economic conditions, and many other factors can be taken into consideration. This is the step where one develops an action plan. At this stage, goals already have been decided on, and a decision must be made on how to achieve them. Personal financial planning is a dynamic process. As such, it is imperative that you review your plan regularly. Many financial planners recommend a complete review at least once a year. Changing personal, social, and economic conditions may require a more frequent review. Cash flow is simply the inflow and outflow of cash during a period of time (e.g., 1 month). Cash inflows include income from salary and interest and investment earnings. Cash outflows can be divided into two categories: fixed expenses and variable expenses. Fixed expenses are stable expenses that do not vary frequently and include rent or mortgage payments, loan payments, cable television payments, and insurance premiums. Variable expenses include items that one might have control over, such as food purchases, entertainment, and clothing purchases. A budget (see Chapter 18) is a spending plan that may help you live within your means, spend money wisely, and develop critical financial management habits. Simply stated, credit is an arrangement to receive cash, goods, or services now and pay for them in the future. There are two basic sources of risk: (1) changing economic conditions and (2) changing conditions of the security issuer. Changing economic conditions include inflation risks, business cycle risks, and interest rate risks. Inflation risk occurs when inflation increases, but the return on one’s investment does not keep pace with it. Business cycle risk refers to the fact that your investments may mirror the fluctuations in the business cycle. Interest-rate risk may occur when interest rates rise, but you have locked into a lower rate on a long-term bond. A second source of risk is the changing condition of the issuer. These risks include management risk (e.g., the company in which you invest has poor managers), business risks (e.g., the risks associated with the company’s products), and financial risks (e.g., the company may borrow too much money and have to declare bankruptcy). Therefore, you cannot expect to receive a greater return for a nondiversified company-specific high-risk investment (e.g., committing all your investment capital to one or two stocks). This is so because the market may do quite well, but one or two companies (the one’s you picked) may go bankrupt owing to management, business, and/or financial risk specific to a few companies. According to Burns (1997), the blueprint for financial security can be narrowed down to seven key principles: 1. Spend less than you earn (e.g., save 10 percent of all wages). 2. Pay yourself first (e.g., have 10 percent taken from your pay check each period, and invest it). 3. Take advantage of free money [always take advantage of employer matching on 401(k) or 403(b) plans]. 4. Keep investment expenses low (the more you pay in investment expenses, the less you will have ultimately). 5. Owe as little as possible (e.g., do not carry credit card balances at high interest rates). 6. Diversify investments. Do not put all your investment eggs in one basket. 7. Trust the power of average. As noted earlier, matching the S&P 500 Index’s return would have been far superior to what the typical investor actually earned.