 Accounting is the dynamic process by which

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.