BSM Connection elearning Course Basics of Medical Practice Finance: Part 2 2009, BSM Consulting All rights reserved.
Table of Contents OVERVIEW... 1 PRACTICE PERFORMANCE RATIOS... 1 UNDERSTANDING THE CONCEPT OF LEVERAGE... 5 EQUIPMENT FINANCING OPTIONS... 5 SAMPLE FINANCIAL MANAGEMENT REPORTS... 7 CONCLUSION... 8 APPENDIX Sample Accounts Receivable Aging Comparison... 10 Sample Accounts Receivable Aging by Payer... 11 Sample Macro Financial Management Report... 12 Sample Monthly Financial Report... 13 Sample Weekly Financial Report... 14 Sample Daily Receipts and Adjustments... 15 Sample Daily Activity by Provider and Practice... 16 COURSE EXAMINATION... 17 2009, BSM Consulting
OVERVIEW This is the second in a two-part series of finance courses designed to provide practice management the essential knowledge to be able to focus on the important financial issues facing the medical practice and to have a clear understanding of the relationship between different financial reporting tools. In part one of the series, information is provided on the forms of doing business, common legal documents, and worker classification status (employee vs. independent contractor). This course, The Basics of Medical Practice Finance Part 2, focuses on several practical tools and information to assist in making better business decisions. Course topics include: an overview of practice performance ratios, different aspects of financial leverage, and different forms of practice financing. Sample financial management and production analysis reports are included to illustrate organization and presentation of information necessary to effectively manage practice financial matters. PRACTICE PERFORMANCE RATIOS The balance sheet and income statement are important tools to enable the practitioner to assess the financial health of the practice. Practice performance ratios are developed utilizing key information, most of which is taken from these reports. The ratios are extremely beneficial in helping to track performance over time and to observe emerging trends. Liquidity Ratios Liquidity is the ability to convert assets to meet currently maturing debts. Tests of liquidity evaluate the degree to which a practice s current liabilities can be met by utilizing current assets. A commonly used test of liquidity is called the current ratio, which is defined as follows: Current Assets Current Ratio = -------------------- Current Liabilities For example, let s assume the following ratio for a sample practice: $200,000 Current Ratio = -------------- = 2.0 $100,000 This ratio points out that this practice has $2.00 in current assets for each dollar of current liabilities. A more demanding test of a practice s liquidity is called the quick ratio. Quick Assets Quick Ratio = -------------------- Current Liabilities Quick assets are assets that can easily be converted into cash such as money market fund balance, certificates of deposit, etc. Typically, inventory and notes receivable could not be readily converted to cash and, as such, would not be included under quick assets. 2009, BSM Consulting 1
Accounts receivable (A/R) are an essential practice asset. How quickly receivables turnover is another way to gain perspective on practice liquidity. An index of this, referred to as days sales outstanding, can be calculated by examining the average daily collections and the adjusted A/R balance as follows: Net Collections Average Daily Collections = -------------------- 365 Days Adjusted A/R Balance = A/R Balance x Gross Collection Ratio Net Collections NOTE: Gross Collection Ratio = -------------------- Gross Charges When calculating the gross collection ratio, we recommend using actual results for the prior 12 months. For example: $3,703,737 Average Daily Collections = --------------- = $10,147 365 Adjusted A/R Balance = $706,987 x.62 = $438,332 $438,332 Days Sales Outstanding = ------------ = 43.2 $10,147 The analysis indicates that this practice collects its receivables in 43.2 days. This information can then be compared with industry norms or tracked over time in order to determine if certain problems exist. In addition, a qualitative analysis of the practice payer mix should also be considered in order to assess the overall health of practice receivables. As an alternative to calculating days in A/R outstanding, it is also recommended a practice assess the number of months of collections tied up in accounts receivable. This is referred to as the A/R ratio. It is calculated as follows: Adjusted Accounts Receivable A/R Ratio = ------------------------------------- Average Monthly Collections For example: $150,000 A/R Ratio = ------------ = 1.5 $100,000 Adjusted accounts receivable are determined by multiplying accounts receivable by the ratio of collections to gross charges over the previous 12 months (gross collection ratio). Efficiency Ratios The receivables ratios noted above are also measures of a practice s efficiency. Rapid turnover of receivables would normally indicate a well-managed billing and collection department. Although not commonly used in medical practices, the inventory turnover ratio is a useful measure of efficiency. 2009, BSM Consulting 2
The inventory turnover ratio is calculated as follows: Annual Cost of Goods Sold --------------------------------------- = Inventory Turnover Ratio Average Inventory for Year Average inventory is generally calculated by taking beginning and end-of-year figures and dividing by two. Remember, inventory is valued at cost. Cost of goods sold is found on the income statement. For example: Cost of Goods Sold = $100,000 ------------------------------------------------------ = 4 Average Inventory = $ 25,000 This tells us that inventory turned over four times per year. The net collection ratio enables the practitioner to evaluate how well office staff is collecting that which they can realistically expect to collect. The net collection ratio is calculated by dividing the collections (net of patient refunds) from practice operations by gross patient billings (less adjustments). For example: Collections Net Collection Ratio = ----------------------- Gross Billings (less adjustments) $1,000,000 Net Collection Ratio = --------------------- = 95.2% $1,050,000 ($1,500,000 gross billings minus $450,000 adjustments) Collections per full-time equivalent (FTE) is another useful measure of practice efficiency. This ratio is especially useful when tracked over a period of months and years. Collections can normally be found on the income statement (for each basis taxpayer). The number of FTEs should exclude any producing providers. To calculate an FTE, divide the actual number of hours worked per year by 2,080. This ratio should yield a monthly or annual figure illustrating the amount of income being generated per full time equivalent employee. For example: Annual Collections = $1,000,000 Collections per FTE = ------------------------------------------- = $125,000 # of FTEs = 8 The non-provider payroll ratio is calculated by dividing the gross wages of non-provider employees by operating revenues. For most medical practices, non-provider payroll is the largest single line item of expense. This ratio should be tracked over time. In addition, target objectives should be considered in the context of establishing the practice budget. Gross Wages Non-Provider Employees Non-Provider Payroll Ratio = ---------------------------------------------------- Operating Revenues 2009, BSM Consulting 3
For example: $240,000 Non-Provider Payroll Ratio = --------------- = 24% $1,000,000 Another variation on this ratio is to add the burden associated with non-provider salaries and calculate a burdened non-provider payroll ratio. Burden would normally include employer paid payroll taxes, as well as employee benefit costs. Profitability Ratios There are many ways to look at practice profitability. Listed below are the most common ratios: Gross Profit Ratio Revenue Minus Cost of Goods Sold ------------------------------------------------ = Gross Margin Revenue Net Profit Ratio Net Income --------------- = Net Margin Revenue This ratio can be calculated on a before or after-tax basis. Operating Expense Ratio Operating Expenses --------------------------- = Operating Expense Ratio Operating Revenue Operating expenses normally would exclude salary, bonuses, and retirement plan contributions paid to or on behalf of the provider/owners. If there are non-owner providers, it is recommended the ratio be calculated with and without these salaries. Use of Performance Ratios We have chosen to omit specific judgment or ranges of reasonable ratios for a variety of reasons. First of all, there is significant variation between practices in terms of services provided. Furthermore, financial reporting systems vary significantly between practices. It is recommended to track practice ratios over time and identify trends and to establish budgetary guidelines or practice goals in the context of specific practice parameters. When used properly, performance ratios can be useful tools. They can stimulate the physician by providing information, which can influence intelligent decision making. By themselves, ratios do not provide answers. Instead, they will allow the physician to focus on the important issues and enable one to frame proper inquiries. 2009, BSM Consulting 4
UNDERSTANDING THE CONCEPT OF LEVERAGE Operating Leverage As noted previously, fixed costs do not vary with the level of output or units of service performed. A practice with high fixed costs is said to have a high degree of operating leverage. Costs vary little with the changes in production. It is important for practices to attempt to leverage their fixed costs through better utilization of practice resources. The contribution margin is the amount remaining after you subtract variable costs from practice revenues. This amount would then be available to cover or leverage fixed costs. This type of analysis can be very helpful in evaluating the economics of different practice expansion or development ideas. As discussed, since fixed costs are constant throughout the relevant range, the key is to increase efficiency of utilization. For example, if a practice has excess exam room capacity, consideration may be given to recruiting a new physician, since this would not increase fixed costs and any contribution margin would be available to cover fixed costs. Financial Leverage A practice with high financial leverage has a high percentage of debt financing as compared to equity financing. Other things being equal, a practice with high financial leverage has greater financial risk than a practice with a low debt-equity ratio. EQUIPMENT FINANCING OPTIONS Almost every practice faces the need to acquire new equipment at some time or another. In some cases, the new equipment is needed to replace outmoded or inoperable items. In other cases, the equipment is needed to expand or enhance the scope of services provided by the practice. In either event, decisions must be made regarding the manner in which the equipment is to be paid. Acquisition usually involves cash purchase, bank financing, or leasing. Each option offers various benefits and disadvantages, depending on the circumstances and objectives of the practice. Cash Payment This option involves writing a check from the practice bank account for the purchase price of the equipment. The transaction is simple: the vendor is paid and the practice then owns the equipment. This option represents the most common method used by practices, especially for lower-cost items. The value of the equipment is fully deductible as depreciation expense over subsequent years; the amounts and timing are defined by appropriate tax and management accounting standards. Since no interest or finance charges are involved, cash payment is usually the least-costly option. Obviously, this method of payment requires the practice to have sufficient cash to make the purchase. In addition, the practice must have sufficient cash reserves available to meet its other payment obligations. The most common problem arising from cash payment is when the practice has insufficient cash to pay year-end profits to the physicians. This may result in taxable income that will be taxed at the entity level or to the individual physician depending on the type of entity, i.e., C or S Corporation, LLC, etc. The taxable income occurs because cash outflows are greater than the depreciation expense charged for the year. In order to avoid or minimize this occurrence, bank financing or leasing may be preferable. 2009, BSM Consulting 5
Bank Financing This option involves arrangement of a conventional bank loan from a local lender. Most banks consider physician practices to be good credit risks and are eager to provide such loans. The transaction involves payment to the vendor from loan proceeds, with the repayment term and interest rate subject to loan provisions. The practice owns the equipment, although the bank will typically retain a lien on the equipment until the loan is paid in full. In this option, the cost of the equipment purchase is fully deductible as depreciation and interest expense. Ideally, the loan term will correspond to the depreciation term, avoiding the unbalanced cash flow problems associated with cash payment. The interest rate for such loans is usually variable, indexed to the prime rate or other reference. The institution used by the practice for its checking and investment accounts will often be the most convenient source for the loan. Nonetheless, the practice should check with at least two other banks to confirm the competitiveness of terms offered. This method assumes the practice has sufficient means to ensure repayment. The bank will confirm this through examination of practice financial statements, income tax returns, and other documents. In some cases, the bank will require the physicians to provide personal guarantees for repayment of the loan. Although many physicians find this objectionable, the process is often necessary to ensure the best possible terms. Leasing Leasing is similar to bank financing inasmuch as the equipment is available to the practice in exchange for a monthly payment. In effect, the practice pays for use of the equipment rather than paying to own the equipment. However, many leases allow the practice to acquire ownership at conclusion of the lease, commonly for one dollar or for 10 percent of then-current fair market value. There are two types of leases capital and operating. From the practice perspective, the differences between the two are typically found in expense recognition and buy out terms. With capital leases, the acquired asset is booked on the balance sheet, resulting in depreciation and interest expense on the profit and loss statement. In the case of an operating lease, lease payments are deductible as a business expense. Regardless of the type of lease, cash flow is balanced since cash outflows and deductibility are matched. The payment amounts are determined by application of a lease factor, dependent on equipment value and the lease term. Unlike bank loans, the lease factor and resultant payments are usually fixed at constant values during the term of the lease. Rates will vary among leasing companies and competitive bids should be obtained from at least three leasing companies. Similar to banks, prospective lessors will request practice financial documents for review. The total costs involved in leasing tend to be greater than those involved in bank financing, especially if state sales tax applies to the entire lease payment. However, when leasing is tied to equipment supply/maintenance discounts or other manufacturer offers, overall costs can be quite competitive compared with other options. The Financing Decision The best decision for the practice depends on several factors: Cash Position: Does the practice have sufficient cash available for the intended financing method and its future cash obligations? Overall Costs: How does the sum of total payments for the intended financing method compare with other methods? Tax Treatment: Will the intended financing method produce tax benefits or tax problems? 2009, BSM Consulting 6
Future Plans: Will the intended financing method allow for needed future acquisitions without depleting the cash or credit capacity of the practice? These questions should be evaluated with the help of the practice accountant or other qualified financial advisor. SAMPLE FINANCIAL MANAGEMENT REPORTS Financial management reports are vital tools for physicians and practice managers to stay well informed regarding practice finances. In addition to the financial reports available on BSM Connection for Ophthalmology, it will most likely be necessary to develop other customized reports to effectively manage the various aspects of practice finances. A series of sample reports is available in this module to illustrate how one can summarize critical information into an easy-to-read, single-page management report. Sample Accounts Receivable Aging Comparison This report provides an overview of the various A/R aging categories by month, which allows management to identify changes in aging and respond appropriately. Additional measures such as gross charges, adjustments, collections, and net collection ratio are also reported as supplemental information. Sample Accounts Receivable Aging by Payer This report illustrates the total A/R balance and A/R aging by individual payers. The payer percent of total A/R and percentages of A/R by aging bucket provides important data to help effectively manage accounts receivable by individual payer. Sample Macro Financial Management Report This single-page report organizes vital information taken from practice financial statements and other reports to allow physicians and administrators to easily understand critical trends in the practice. Financial summary reports, such as this example, can be customized to meet the needs of practice management; however, it is important to keep the report concise, simple, and limited to essential information. Sample Monthly Financial Report Similar to the macro financial management report, this summary provides a synopsis of essential information at month end, as well as year-to-date results, and comparison to budget year-to-date and prior year-to-date results. Sample Weekly Financial Report This report tracks cash on hand at week end, as well as total charges, adjustments, collections, and accounts receivable. In addition, patient encounter statistics are provided. Sample Daily Receipts and Adjustments Patient payments, insurance payments, and adjustments are reported on this day sheet which allows the practice to balance payments on a daily basis. 2009, BSM Consulting 7
Sample Daily Activity by Provider and Practice This report provides a daily summary of current accounts receivable, charges, payments, and adjustments by provider and for the total practice. CONCLUSION Effective financial management requires physicians and managers to gain solid, foundational knowledge and expertise in practice financial matters. In order to make well informed decisions, practice leadership must have the ability to review essential financial information presented in a concise and timely manner. Appropriate review, reporting, and governance structures within the practice will allow managers and physicians to work as an effective and efficient team. By doing so, the practice can enhance its prospects for future success. 2009, BSM Consulting 8
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COURSE EXAMINATION 1. The current ratio is a commonly used test of business liquidity. a. True b. False 2. Which of the following is an accurate statement? a. The inventory turnover ratio is never used with medical practices. b. The net collection ratio enables a practitioner to evaluate how well staff is collecting that which they can reasonably be expected to collect. c. The current ratio helps to measure operating efficiency. d. A full-time equivalent (FTE) is calculated by dividing the actual number of hours worked by 2,080. e. All of the above. f. B and c. g. B and d. 3. In calculating the net collection ratio, contractual adjustments are subtracted from gross charges or billings in the denominator of the equation. a. True b. False 4. Which of the following is true concerning the ratio of collections per (FTE)? a. This is a useful measure of practice efficiency. b. This ratio is most helpful when measured over a period of months and years. c. The number of FTEs should exclude physicians. d. Collections are generally found on the income statement for a cash basis taxpayer. e. A, c, and d. f. B and c. g. All of the above. 5. Which of the following is the formula for calculating the non-provider payroll ratio? a. Net wages after withholding divided by operating income. b. Gross wages of non-physician employees divided by total operating expenses. c. Gross wages of non-physician employees divided by operating revenues. d. None of the above. 6. A practice with high fixed overhead is said to have a high degree of operating leverage. a. True b. False 7. Which of the following are common financing options for medical practices? a. Operating leases. b. Capital leases. c. Lines of credit. d. Term financing. e. All of the above. 2009, BSM Consulting 17
8. Which of the following is true with respect to bank financing? a. The bank will normally not require a lien on equipment since doctors are good credit risks. b. Principal payments on bank debt are considered normal operating expenses. c. Depreciation and interest are the deductions normally associated with equipment purchased with bank financing. d. Personal guarantees are never required on equipment purchases financed through a bank. 9. In the case of an operating lease, lease payments are treated as a normal business expense. a. True b. False 10. In the case of a capital lease, the leased equipment and related debt is recorded on the balance sheet. a. True b. False 2009, BSM Consulting 18