Managerial Accounting

Upon successful completion of this program, the participant will be able to do the following plus more: 1. Differentiate between financial and managerial accounting 2. Define financial analysis 3. List 3 accounting terms related to current assets 4. List 1 financial ratio for each of the following categories a. Liquidity b. Solvency c. Profitability d. Activity 5. Define the parts of an income (financial) statement 6. Define BEP 7. Calculate a "ball-park" BEP for community pharmacy using a financial statement 8. Describe the cash flow process 9. Determine the financial position of a pharmacy as to profitability and liquidity by sing financial ratio analysis

Managerial Accounting

One of the major steps in managerial accounting is financial analysis or a systematic means of determining how well the assets of a business are tools to assess where the firm is, where the firm has been, and what can be done to put the firm on track as to where the manager wants the firms to go.

a. Financial vs. Managerial Accounting

Financial accounting is involved with record keeping; for example, ledgers, invoices, preparing balance sheets, and financial statements. It is more externally oriented in that these records are used to report to creditors, employees, stockholders, and are a means of determining income. Financially accounting is an effort is an effort to keep track of the economic events in a firm. You record those events that can be defined in terms of dollars. In developing a financial accounting program, the bookkeeper will first of all have a journal. A journal is kept for each group of like transactions and are books of original entry.

The next step in the process is accumulation. It is done monthly and the journal information is placed into a ledger. A ledger is a book of accounts in which you accumulate data. The volume of work determines the number of ledgers that are kept. For tax purposes and for reporting to creditors, unions, employees, and trade journals, balance sheets and operating statements are prepared. Thus, the major objective of financial accounting is the development of a balance sheet and an operating statement.

Figure A-1

The balance sheet is a snap-shot of the firm at any given point in time. It lists the firms' assets and compares them with the firms' liabilities. When liabilities are subtracted from assets the net worth of the individual or firm can be determined. Another term for net worth is owner's equality.

Assets = Liabilities + Net worth

Assets are items, which are owned and considered the property of the business. Assets can be further broken down into current assets. Current assets are those times, which are either cash, or things, which may be converted into, cash in the normal course of business within the accounting period. Current assets include such things as cash on hand, cash in the bank, merchandise stock (inventory), accounts receivable, notes receivable, and accrued interest receivable. Other assets include fixed assets. These are non-cash items which are not to be sold, but are to be used and, as a rule, worn-out and depreciated by the business. They include such things as land, buildings, furniture and fixtures, and equipment - such as delivery trucks, heating unit, machinery, etc.

To offset the assets, we have on the other side of the equation, liabilities and owner's equality. Liabilities include items, which aren't owned by the business. Some of these items are also referred to as creditor's equities. Liabilities can be broken down into current liabilities and long-term or fixed liabilities.

Current Liabilities are debts, which are generally payable within the accounting period, and include such things as:

1. Accounts payable
2. Notes payable
3. Accrued taxes payable

Fixed Liabilities are debts, which will not come due during the normal accounting period, and include such things as:

1. Long-term notes payable
2. Long-term mortgages payable

When one subtracts liabilities from assets, net worth is determined. Other terms for net worth include owner's equity or owner's net interest in the business.

Another financial accounting record that is commonly prepared is the operating statement and often referred to as the financial statement or profit and loss statement. In it, you list sales, cost of goods, expenses and net profit.

Sales-Cost of goods sold = Gross Margin

From Gross Margin expenses are subtracted to yield net profit before taxes. Operating expenses are often divided into fixed expenses and variable expenses. Thos that are fixed include such things as the proprietor's salary; employees wages; rent; heat and air conditioning; lights and power; taxes on furniture, fixtures and equipment; interest on barrowed money; and depreciation on furniture, fixtures and equipment. Fixed expenses are those expenses that you would have whether you sell any items in the store or not.

The variable expenses which can include some of the proprietor's salary; some of the employees' wages; advertising and display; delivery costs; wrapping material and supplies; barrowed debts charged off; taxes on merchandise and supplies; insurance on merchandise and supplies telephone and repairs are also included. Variable expenses are those that vary with the amount of sales.

The profit and loss statement is a moving picture of the firm over the accounting period.

Managerial accounting, on the other hand, is concerned with determining costs and synonym for it is cost accounting. It is used for internal purposes and providing information to managers so that they can make better decisions and have a better means of planning, organizing, and controlling business. The objectives of managerial accounting are as follows:

1. It provides information for managers
2. Through managerial accounting, you can determine where costs have come from and how much income is really worth.
3. You make sure resources are being used effectively and efficiently
4. The information is used for making decisions.

Under managerial accounting, you have such processes as the following:

1. Cash flow analysis
2. Break-even point analysis
3. Budgeting
4. Financial ratio analysis

In summary, financial accounting is external oriented and results in the development of a balance sheet and a financial statement. The purpose of determining a balance sheet is to compare assets to liabilities and to determine net worth. The purpose of the financial statement is to determine net profit so that this can be reported to the federal government and other outside groups. Managerial accounting, on the other hand, uses the information in the balance sheet and profit and loss statement in a comparative manner to allow the manager to make decisions to better plan, organize, and control the operations of the business.

Financial Ratio Analysis

It is useful to classify ratios into four fundamental types

1. Liquid ratios which measure the firm's ability to meet current financial obligations using its readily available assets
2. Solvency or leverage ratios, which measure the extent to which the firm has been financed by debt. From this, one can determine the barrowing potential of the firm and the extent to which the pharmacy is leveraged
3. Activity ratios which measure how effectively the firm is using its resources
4. Profitability ratios, which measure the management's overall effectiveness as shown by the returns generated on sales and investment.

Remember that having a common basis of comparison by using financial ratios is the heart of financial analysis. In other words, a firm that has sales of $2 million dollars and generates a $30 thousand dollar profit is financially not as good as a firm that has $200 thousands dollar sales and generates a profit of $20 thousand dollars. By comparison of ratios, it is easier to determine whether or not a firm is healthy or unhealthy

The analysis of ratios in a variety of categories gives the manager information about how the firm compares over a period of time and this information can be taken and measured with similar firms in the same industry to determine how it compares with other firms. The principal value of ratio analysis is that when they are computed and standardized, the ratio has considerably more usefulness than the raw data upon which it was computed. Before using ratio analysis, the following guidelines must be employed:

1. Ratio analysis must be based upon meaningful financial statements predicted upon sound and accepted accounting theory and practice.
2. Ratio analysis must be used in conjunction with reliable and accepted standard ratios in order that meaningful analysis, comparison, and interpretation can be undertaken.
3. The decision-maker analyst must know what ratios are worth computing and the relative strengths or weaknesses of the various ratios.

Computing ratios is not the important thing to learn. Instead, you should be concerned with interpreting the results and their significance.

1. Liquidity Ratios

a. Current Ratio= (Current Assets/ Current Liabilities)

The minimum desired value for the current ratio is 2:1, although it is not uncommon for the current ratio of a well-established pharmacy to reach 3:1.

b. Acid Tests = (Quick Assets/Current Liabilities) = (Current Assets-Inventories/ Current Liabilities

The acid test or quick ratio gives a more accurate picture of the cash situation. It is used to test the firm's immediate ability to meet current liabilities. The acceptable or standard liquidity ratio or acid test or quick ration is 1 to 1. The value of 8:1 is undesirable because it indicates that company cannot meet the current liabilities without reducing the level of inventory.

c. Inventory to Net Working Capital

This ratio provides an indirect measure of liquidity. It simple takes the inventory from the balance sheet and divides it by net wrong capital. Networking capital is determined by subtracting current liabilities from current assets. In most pharmacies, the value is between 80% and 120%. The desirable value is between 90% and 100%. If this ratio exceeds 100%, is indicates that the pharmacy has too much inventory and is probably scoring low on the acid test ratio as well.

2. Solvency Ratios

a. Total Liabilities/Net Worth

This ratio compares net worth or owner's equity with the total obligations of the firm. Thus, the value should be less than 100%. For established pharmacies that are five or more years old, the desirable total liabilities to net worth ratio is 50% or less. For pharmacies less than five years old, it should be somewhere between 50% to 100%.

b. Funded Debt / Net Working Capital

Another indications of the financial position of a pharmacy are the ratio of the funded debt refers to long-term liabilities. For example; funds barrowed for longer than one year. A low ratio indicates the ability of a pharmacy to borrow money for working capital if necessary. It is generally considered desirable for a pharmacy over five years of age to have a funded debt to net working capital ratio of 50% or less.

c. Average Remittance Time of Accounts Payable

This determination shows how well the pharmacy is able to pay creditor. It is determined by taking the total purchases for the pharmacy for one year and dividing by the accounts payable. This value is termed the accounts payable turnover. When it is divided into 365, it gives the number of days it takes the pharmacy on the average to pay its debts. Any value less than 40 days is considered good.

d. Fixed Assets/ Net Worth

If this percentage exceeds 75%, too much capital is tied up in fixtures and other fixed assets. If the value is 10% or less it probably means that the pharmacy should buy new fixtures.

3. Activity or Efficiency Ratios

These ratios need to be viewed with all of the other ratios determined in order to accurately pinpoint the efficiency of the firm.

a. Inventory Turnover Rate

This is the most frequently used ratio in the efficiency category of financial analysis. Inventory turnover rate is computed by utilizing the following formulas:

Inventory Turnover Rate = Cost of Goods Sold/ Average Inventory Cost

(This ratio will increase or decrease in direct proportion with sales volume. The ratio of 3 is considered a minimum rate of turnover. A ratio value of 8 is considered to very good.)

b. Net Profit/Inventory

This ratio is a good indicator of both the efficient use of inventory and profitability. Target value of $.20 is desirable for this ratio and should be attainable for all pharmacies except very young ones.

c. Average Accounts Receivable Collection Period

This is a ratio that measures the efficiency of a pharmacy's credit program. The formula for this ratio is:

365 days/Average Accounts Receivable Turnover

The average accounts receivable turnover is calculated by taking the credit sales and dividing it by the accounts relievable. An average of 30 days or less is desirable value for the average accounts receivable collections period ratio. It is larger than 30 days, it means that money is tied up in accounts receivable and is not available for regular operation for special purchases.

4. Profitability Ratios

a. Net Profit / Net Sales

5% is the target level for this ratio. Many retail pharmacies are now under the 5% level.

b. Net Profit/Net Worth

This compares the amount of profit made to the owner's equity. 20% is considered a minimum, and 25% a reasonable goal.

c. Net Profit/Total Assets

When one compares the amount of money made to the total assets of the firm, it gives a good indication as to profit vs. investment. The ideal number for this ratio varies but 15% is considered normal.

d. Net Profit /Total Investment

Total investment is determined by adding owner's equity plus long-term liabilities. A 20% return on investment is considered normal.

e. Net Profit / Net Working Capital

This should provide a percentage of somewhere between 27% to 30% if the firm is operating efficiently.

Refer to the next page that shows the Dupont Return-on-Investment Schematic a Framework for Financial Planning. As one looks at the return-on-investment it can be determined when profit margin is multiplied by investment turnover. If you evaluate this formula, the top part of the Return -On- Investment Schematic can be taken from a balance sheet and the bottom part can be taken form a financial statement. It gives a good visualization as to the factors that influence return-on-investment

Framework for Finacial Planning

C. Cash Flow Analysis

The proper management of the cash flow is important at any time and is vital in periods of inflation and high capital cost. Figure 1 illustrates the key role that cash flow plays in the normal operation of a business.

There are many reasons for a pharmacy manager to be concerned about maintaining an appropriate cash flow. Cash flow, for example can provide sufficient funds to:

1. Pay accounts payable and other bills on time in order to earn cash discounts.
2. Pay normal day-to-day expenses.
3. Maintain a good credit rating
4. Take advantage of special-purchase opportunities.

In order to maintain adequate cash flow, the manager must be concerned about several potentials problem areas. These sensitive areas are:

1. Inventory Control
2. Accounts Receivable Control
3. Fixed and variable expense control
4. Debt service or loan interest expenses

It also requires the manager to ask his or her accountant to prepare a source and uses of funds statement and to develop a cash budget. The sources and uses of funds statement or the cash flow statement takes information from the balance sheet and financial statement of the firm and summarizes it in a way that shows where funds come from and where funds have been used. Sources of funds include things like decreases in cash, ddecreases in accounts receivable, decreases in building, decreases in prepaid expenses, increases in notes payable, and increases in accounts payable. Uses of funds include things such as increases in inventory, increases in notes receivable, and decreases in mortgage payable.

Operating transactions are estimated for each month so that total cash payments can be projected. Thus, it is possible to determine the net monthly cash gain or loss, receipts minus the payments.

By following these steps or having your accountant prepare a cash low budget, it is then possible to determine which month you will have an excess of cash, and which months you will need to barrow money to keep a healthy flow of cash. Some of the following steps can be taken to improve cash flow.

1. Reduce accounts receivables
2. Reduce inventories
3. Reduce prepaid expenses
4. Reduce land
5. Reduce building area
6. Reduce fixtures and equipment
7. Increase accounts payable
8. Increase or reduce short-term borrowing
9. Increase barrowing in the long-term
10. Increase owner's equity
11. Increase retained earnings
12. Reduce cash dividends.

D. Break-even Point Analysis (B.E.P)

Besides cash flow analysis and ratio analysis, pharmacist and other businessmen may use a procedure called break-even point analysis or cost, profit and volume analysis.

The purpose of the break-even point analysis is to determine the amount of sales required to break-even with the cost of any particular fixed outlay of capital either on an annual basis or on a project basis such as remodeling. One could determine then if you close the pharmacy later how many additional sales will be required in order to meet the additional expenses of staying open longer. If you are faced with a new advertising program you can estimate the additional sales that will be required to pay for the advertising program. If you decide to increase your professional fee in the pharmacy, you can determine the effect that this will have on then net profit. Thus, break-even point becomes a very useful managerial tool in the planning process.

In order to calculate the break-even point it is first necessary to arrive at a factor called the "marginal income ratio (MIR) - that percentage of sales left over, after paying all variable expenses, to cover fixed expenses and net profit. The MIR is determined in the following manner:

1. Classify all expenses as either variable or fixed. For the purpose of this calculation, variable expenses include only employee wages, advertising, bad debts and miscellaneous expenses.
2. Determine the variable expenses as a percentage of total sale3s.
3. Subtract the variable expenses percentage from the gross margin percentage to determine the MIR.

Basically what we are trying to do in determining the MIR is to see how much of each item sold can be used to overcome the fixed expenses of the firm. For example; a pharmacy sells a Hershey Bar for $.20 and it cost the pharmacy $.12 for the Hershey Bar and $.02 to sell it, $.06 of that sale is contributing to overcoming fixed expenses and profit. To determining the break-even point, the fixed expenses of the firm are divided by the marginal income ratio (MIR). This will provide the number of dollars that will be necessary in sales for the firm to break-even. Once this is determined it can then be used to plan additional expenses or additional income and what affect that will have on contributions to profit. Individuals that would like more information on this subject should refer to the: Effective Pharmacy Management Text" published by Marion Laboratories.

A ball-park method for determining break-even point can be calculated in a matter of seconds and involves taking the total operating expenses from the profit and loss statement and assuming that most of these expenses are fixed. The gross margin is used to determine the MIR when the gross margin as a percent of sales is divided into the total operating expenses. This will give you a ballpark figure for the break-even point. This simply allows managers to get a rough estimate of how sales are required when the firm will break-even and there is not a profit nor a loss.

Ball Park (B.E.P) = Operating Expenses
Gross margin as % of Sales