BSM Connection™
eLearning Course
General Business
Basics of Medical Practice
Finance: Part 2
© 2009, BSM Consulting
All rights reserved.
Basics of Medical Practice Finance: Part 2
General Business
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
Basics of Medical Practice Finance: Part 2
General Business
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 Ratio
=
Current Assets
-------------------Current Liabilities
For example, let’s assume the following ratio for a sample practice:
Current Ratio
=
$200,000
-------------$100,000
=
2.0
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 Ratio
=
Quick Assets
-------------------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.
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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:
Average Daily Collections
Net Collections
= -------------------365 Days
Adjusted A/R Balance
= A/R Balance x Gross Collection Ratio
NOTE: Gross Collection Ratio
Net Collections
= -------------------Gross Charges
When calculating the gross collection ratio, we recommend using actual results for the prior 12 months.
For example:
$3,703,737
--------------365
Average Daily Collections
=
= $10,147
Adjusted A/R Balance
=
$706,987 x .62 = $438,332
Days Sales Outstanding
=
$438,332
-----------$10,147
=
43.2
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:
A/R Ratio
=
Adjusted Accounts Receivable
------------------------------------Average Monthly Collections
=
$150,000
-----------$100,000
For example:
A/R Ratio
=
1.5
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
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The inventory turnover ratio is calculated as follows:
Annual Cost of Goods Sold
--------------------------------------Average Inventory for Year
= Inventory Turnover Ratio
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
-----------------------------------------------------Average Inventory
= $ 25,000
=
4
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:
Net Collection Ratio =
Net Collection Ratio =
Collections
----------------------Gross Billings
(less adjustments)
$1,000,000
--------------------$1,050,000
=
95.2%
($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:
Collections per FTE =
Annual Collections = $1,000,000
------------------------------------------# of FTEs = 8
= $125,000
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.
Non-Provider Payroll Ratio =
© 2009, BSM Consulting
Gross Wages Non-Provider Employees
---------------------------------------------------Operating Revenues
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For example:
Non-Provider Payroll Ratio =
$240,000
--------------$1,000,000
= 24%
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
-----------------------------------------------Revenue
=
Gross Margin
Net Profit Ratio
Net Income
--------------Revenue
=
Net Margin
This ratio can be calculated on a before or after-tax basis.
Operating Expense Ratio
Operating Expenses
--------------------------Operating Revenue
=
Operating Expense Ratio
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.
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Basics of Medical Practice Finance: Part 2
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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
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Basics of Medical Practice Finance: Part 2
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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?
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•
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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.
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Basics of Medical Practice Finance: Part 2
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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
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APPENDIX
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COURSE EXAMINATION
1. The current ratio is a commonly used test of business liquidity.
a.
b.
True
False
2. Which of the following is an accurate statement?
a.
b.
c.
d.
e.
f.
g.
The inventory turnover ratio is never used with medical practices.
The net collection ratio enables a practitioner to evaluate how well staff is collecting that
which they can reasonably be expected to collect.
The current ratio helps to measure operating efficiency.
A full-time equivalent (FTE) is calculated by dividing the actual number of hours worked
by 2,080.
All of the above.
B and c.
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.
b.
True
False
4. Which of the following is true concerning the ratio of collections per (FTE)?
a.
b.
c.
d.
e.
f.
g.
This is a useful measure of practice efficiency.
This ratio is most helpful when measured over a period of months and years.
The number of FTEs should exclude physicians.
Collections are generally found on the income statement for a cash basis taxpayer.
A, c, and d.
B and c.
All of the above.
5. Which of the following is the formula for calculating the non-provider payroll ratio?
a.
b.
c.
d.
Net wages after withholding divided by operating income.
Gross wages of non-physician employees divided by total operating expenses.
Gross wages of non-physician employees divided by operating revenues.
None of the above.
6. A practice with high fixed overhead is said to have a high degree of operating leverage.
a.
b.
True
False
7. Which of the following are common financing options for medical practices?
a.
b.
c.
d.
e.
Operating leases.
Capital leases.
Lines of credit.
Term financing.
All of the above.
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8. Which of the following is true with respect to bank financing?
a.
b.
c.
d.
The bank will normally not require a lien on equipment since doctors are good credit
risks.
Principal payments on bank debt are considered normal operating expenses.
Depreciation and interest are the deductions normally associated with equipment
purchased with bank financing.
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.
b.
True
False
10. In the case of a capital lease, the leased equipment and related debt is recorded on the balance
sheet.
a.
b.
True
False
© 2009, BSM Consulting
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