While many important non-financial considerations contribute to a decision regarding a practice opportunity, this component of the Tool Kit will focus on key financial concepts.
The purpose is to provide: (1) an introduction to medical practice financial concepts; (2) insight into key issues related to group practice financial performance; and (3) probing questions to better understand the financial potential of an opportunity.
In the process of exploring a practice opportunity, unless a physician is seeking to accomplish some very specific short-term (1 – 2 years) objectives from their selection, opportunities should be evaluated in terms their of medium (3 – 5 years) to long-term (6+ years) potential. Be aware that a relatively good compensation package for the first 2
years may not translate into the best medium to long-term economic opportunity. Several of the components of the Tool Kit are designed to assist in gaining insight into
the medium to long-term financial prospects of practice opportunities. Fundamental to the Tool Kit are components providing tools to understand and assess group practice
financial condition, physician compensation methodologies and practice structure models. While this component of the Tool Kit focuses on assessing group practice
financial condition, each of these elements share common financial threads and an understanding of these is critically important in an overall assessment of an opportunity.
Financial Assessment Overview
The financial condition of the practice is extremely important in determining the medium to long term potential of the opportunity. The practice will usually provide a fairly clear
picture of the first two years of the opportunity. The goal in financial assessment is to gather as much relevant financial information as is necessary and feasible to assist in
making appropriate decisions regarding the medium to long-term prospects of the opportunity.
Financial and practice management system reports provide the basis for gaining an understanding of the practice’s financial condition. An accountant usually develops
financial reports in the form of monthly, quarterly or annual compilation reports. Practice management reports are usually generated by the software utilized for billing and patient account management. Often, practices are reluctant to share financial and practice management reports to a prospective physician employee. This is understandable,
since typically only physician shareholders are privy to such confidential and proprietary information. However, if an offer has been extended, a request to review such information in an effort to determine the medium to long-term prospects of the opportunity is a reasonable request. Chances are good that if requests are persistent, the group will honor the request.
The balance sheet provides information about the assets and liabilities of the group. An example of a balance sheet is provided in Appendix A, Exhibit 1. Assets include furniture, fixtures and equipment (FF&E). These assets are also referred to as plant, property and equipment (PP&E). If the group is well established, most of these assets will be almost completely depreciated. Depreciation is an accounting method that recognizes the useful life of assets. A common method for calculating depreciation is straight-line depreciation. For example, a computer purchased last year for $1,500 with a useful life of three years is depreciated at $500 per year. This expense would be reflected on the income statement. The $500 per year would accumulate on the balance sheet as “accumulated depreciation” until the computer is fully depreciated. If the group financed the purchase, a corresponding liability would reflect on the balance sheet.
Assessing the balance sheet provides a good understanding of the investments that have been made in the practice and the debts that must be paid. It is important to assess the balance sheet to determine if the group is borrowing to invest in the group’s growth, or borrowing to maintain a level of physician compensation not warranted based on the group’s profitability. If credit lines have been drawn upon, determine what uses those funds have been employed by and whose responsibility it is to repay the loans. If a new physician will have the opportunity to become a shareholder, it is important to determine what, if any, existing debt will be assumed by the new physician.
The income statement provides a picture of the revenues, expenses and net income of the group and is the single most important document in assessing financial condition. An example of an income statement is provided in Appendix A, Exhibit 2. The first step is to determine if the group is utilizing a cash basis or an accrual basis of accounting. Most groups utilize a cash basis of accounting, meaning revenues are recognized when money is collected and expenses are recognized when items are paid for (not necessarily when they are used). This is a simple method of accounting and easy to understand. The accrual method is more sophisticated and provides a better understanding of financial erformance by matching revenue with the expenses incurred to generate such revenue. Accrual accounting recognizes revenues when services are performed and it recognizes expenses when they are incurred to generate such revenue.
For example, in a cash accounting scenario, if a physician performs a service today the revenues from that service will not be recognized for two to three months, when payment
is received. If a malpractice insurance premium is due today, it is paid and reflected as an expense today. At the end of the month, when the income statement is prepared,
there would be no revenues for the services performed during the month while 100% of the expense for the malpractice insurance would be recorded. This method does not
provide an accurate picture for the month. The malpractice insurance insures the physician for twelve months, not just the current month. In an accrual basis of
accounting, the malpractice expense is spread out across the period it is utilized. If a service were performed today, the revenues, net of estimated allowances and
adjustments, would be recorded today. At the end of the month, when the income statement is prepared, revenues for the services performed during the month and 1/12
of the expense for the malpractice insurance would be recorded.
The method of accounting used by the practice should be understood prior to beginning an assessment of profitability. This may not be a major concern during a fixed salary
period, but when there is an opportunity for bonuses or compensation tied to profitability, knowing when and how revenues and expenses are recorded is important.
Keep in mind that when a practice utilizes a cash basis of accounting, it will not recognize a break-even for a new physician for several months. If the current shareholders are funding the deficit, they are motivated to bring a new physician to profitability as quickly as possible.
Net revenues are a good measure for the productivity and management performance of a practice. For example, if the most recent financial statements are for November of the
current year, take the net revenues (revenues after any adjustments such as refunds and contractual adjustments) and divide by 11 to determine the average monthly net revenues. If the group’s fiscal year is not the same as the calendar year, determine how many months into the fiscal year the group is and follow the same methodology. Once
the average monthly net revenues are determined, multiply by 12 to calculate the annualized net revenues. Again, if the group uses a cash basis of accounting, net revenues may be referred to as cash collections.
Review the fiscal year end income statements for the past 3 years and determine annual net revenue. Compare the growth from one year to the next. For example, if the year 1
fiscal year income statement indicates net revenue of $4,000,000 and the year 2 fiscal year income statement indicates net revenue of $4,400,000, then the group has realized
a 10% growth in net revenue in year 2. However, if year 2 net revenue is $3,600,000, then the group has had a 10% decline. In any either case, be sure to understand the
trend. What are the drivers of change? Has physician productivity changed? Have reimbursement rates changed?
While an understanding of changes in net revenues is important, equally important is an understanding of changes in practice expenses. Changes in practice expenses in
relation to changes in net revenue impact net income, and net income translates into physician compensation.
Cash Flow Statement
Cash flow is the lifeblood of a medical group and is particularly critical during the start-up of a new practice. Many practices do not regularly prepare a cash flow statement, but an understanding of its purpose is useful. A cash flow statement provides information regarding the sources of cash, or inflows, and the uses of cash, or outflows, and
explains the resulting increase or decrease in the group’s cash position.
Fixed and Variable Costs
Fixed and variable costs are often referred to as “overhead.” For most groups, costs for rent, equipment leases, full-time salaries of employees and professional liability
insurance are relatively fixed. As a result, declines in physician productivity, decreases in reimbursement rates or the loss of a large managed care contract can significantly
reduce group net income unless changes to fixed costs are made. Such changes might require reduction of staffing levels and office space.
Understanding fixed and variable cost structure is important in evaluating how changes in net revenues impact a group’s net income. Generally, variable costs move in relation
to volume, while fixed costs are not effected by volume. For example, the rent paid by a group is a relatively fixed cost from month to month regardless of the number of patients
treated or the number of hours worked by a physician. Thus, total annual rent expense is generally a fixed cost. If revenues decline, rent becomes a greater percentage of total
cost for the group, and unless other costs of the group are reduced, net income will decrease with declining net revenues. If revenues increase, rent becomes a smaller
percentage of total cost for the group, and unless other costs increase at a greater rate than net revenue, net income will increase.
Unlike rent, medical supply usage increases with the number of patients treated. For example the number of syringes used by the group varies with the number of patients
requiring a vaccination. Thus, the total cost of syringes for the group varies with the number of syringes used. In this example, if net revenues decline due to a reduced
volume of patients requiring vaccinations, then total variable costs associated with syringes will decline as well. Generally, variable costs as a percentage of net revenues
are stable, that is they tend to move in the same direction as net revenue.
Understanding the differences between fixed and variable costs assists in understanding what a change in net revenue means for a practice and consequently, physician income.
In addition, it provides insight into the nature of group expenses during the first year employment of a new physician. Often, the addition of a new physician will create
greater economies of scale and reduce some group costs. For example, if current office space is sufficient for the addition of a new physician, then the new physician will reduce
the per physician space cost for the group. In this scenario, office space for the new physician would not be an incremental expense for the group. If new space is required
then fixed costs increase. If the group must hire additional full time staff to support the new physician, then the group has added a semi-fixed cost. The new physician’s net
revenues must offset these and other costs for the group to realize an incremental profit.
As net revenue increases or decreases, the relative amounts of fixed versus variable costs significantly impact the resulting change in the group’s net income. If net revenues
are increasing or decreasing, determine the corresponding increase or decrease in net income as a percentage of total net revenues. Usually, increasing revenue is due to increasing patient volumes and has associated costs. In most cases, increasing revenue is not the result of better reimbursement. Increasing patient volumes usually requires the addition of fixed costs such as additional office space and staff. Most practices are predominantly characterized by fixed costs such that declining net revenues from lower reimbursement has a greater impact on net income.
Determine if net income is improving, declining or steady. Understand the net revenue, overhead expense and net income trends. More importantly, attempt to understand the
fundamental reasons for these trends and their potential implications.
Determine the group’s expectations regarding productivity, fixed and variable expenses and profitability of a new physician in the first year of practice. If the group anticipates a
loss, determine if the shareholders will absorb the loss or if a third-party income guarantee will be sought. If a third party will be involved in the funding of the first year,
determine what the requirements of that funding will be. If the group anticipates a loss in the first year, determine if that will impact compensation in the second year. If the group anticipates a profit in the first year, determine if a bonus opportunity will be available, and if so, how it will be calculated.
Break-even and Profitability
Most new physicians run a financial deficit for some period of time during the start-up of their practice. How long depends on the amount of time required for the new practice to
reach “break-even.” Break-even is the point where net revenues (or cash collections in cash basis accounting) equal expenses. For instance, if first month billings are $20,000
resulting in net revenues of $12,000 (adjusted for contractual allowances) and expenses equal $18,000, then the group has a $6,000 deficit for the month. In this example,
break-even, would be net revenues of $18,000 for the month.
The example above assumes the group employs an accrual basis of accounting. Most groups utilize a cash basis of accounting. In a cash basis of accounting, revenues are
not recognized until cash is collected from the patient or the patient’s insurance company. With a cash basis of accounting, the group would show a deficit until the cash
is collected, which could take 30 – 45 days from the date the service is billed to the patient or insurance company. For instance, if first month billings are $20,000 and cash
collections from patient co-pays or deductibles are $1,500 (with the balance billed to insurance companies), and actual expenses for the month of $21,000, then the group
has a $19,500 deficit. Unless there is some form of income guarantee from a third party, the shareholders of the group must fund the deficit from funds that would have been
income to them.
Costs associated with a new physician start-up may include items such as salaries and benefits for additional staff, additional office space, equipment and furnishings, updated
letterhead and business cards, brochures and related marketing items, and communication and information system additions. In most specialties, group overhead
ranges from 40% to 60% of revenues. Assuming a 50% overhead means that collections for a new physician must equal twice the expenses related to the new
physician for the group to break even. Understanding the financial condition of the group assists in estimating the costs associated with a new physician joining the group
and the likely impact when there is no longer a guaranteed base salary.
Determine the length of time required for other physicians in the group to reach break-even and profitability. The period of time that it takes to build a practice to break-even
and to profitability is often referred to as the “ramp-up” time. The shorter the ramp-up time, the sooner a fixed salary employed physician generates a profit for the group. Any
profits earned during the fixed salary period will likely be distributed to shareholders of the group since the group bears the associated financial risks and assists in the new
practice ramp-up. The level of profits retained by the group may be negotiable.
Practice Management System Reports
Determining the gross charges, payments and adjustments for each physician and how this information translates into physician compensation is important. Every practice is
unique in their method of compensating physicians. While the compensation methodology for non-shareholders is usually simple and easy to understand, the shareholder methodology may be more complex. Under most circumstances, the profitability of the group is taken into consideration in determining shareholder compensation. Gaining an understanding of how current shareholders are compensated in relation to their individual patient charges, payments, contractual adjustments as well as expenses is important, especially if there is an opportunity to become a shareholder of the practice. (See physician buy-in in the Tool Kit).
Determine the components of the compensation formula and request to see anonymous practice management reports for other physicians in the group for both shareholders and
non-shareholders. An explanation of the calculations for a current physician’s previous month will provide clarity in understanding how productivity and profitability translates
into physician compensation.
The current procedural terminology (CPT) code report indicating codes billed by the group, provides information about the services predominantly provided by the group.
This report provides a good indicator of the group’s interests and areas of expertise and allows a new physician to determine if such interests and areas of expertise are congruent with their own. In addition to an understanding of the services that drive group revenue, the CPT code report provides an opportunity for a new physician to determine what services could be added to the group. Special skills, training or knowledge is an added selling point over other candidates and could be a negotiating point in determining salary.
Aging of Accounts Receivable Report
Accounts receivable (A/R) is the amounts due from a debtor, such as an insurance company or patient on an account that is being carried on the group’s books. The total
A/R of a practice indicates the total dollars outstanding and due to the practice.
Determine how the group performs in collecting payments due for services rendered by calculating the gross collection ratio and the net collection ratio. The gross collection
ratio provides insight into the pricing level and contractual adjustments of the practice. The net collection ratio provides insight into management’s performance of collecting
amounts due after contractual adjustments have been made.
For example, if total billed charges for the period are $4,000,000 and total collections are $2,000,000, then the gross collection ratio is 50%. Without considering the amount of
contractual adjustments, it would be difficult to determine if this is an acceptable or unacceptable level of performance. Contractual adjustments represent the difference
between what the group charges for a service, and the amount it has agreed to accept as payment through a contractual arrangement. For instance, if the historical contractual
adjustment rate of the practice is 30%, then one would expect that on gross billings of $4,000,000 the group would collect around $2,800,000; therefore, in this example,
$2,000,000 in collections might indicate a problem in A/R management.
By calculating the net collection ratio, a better understanding of A/R management performance is gained. Using the same example, if billed charges are $4,000,000 and
contractual adjustments are $1,200,000, then expected net collections at 100% would be $2,800,000 and any thing less would reflect on the performance of A/R management. If
collections are actually $2,000,000, then the net collection ratio in this example is around 71% ($2,000,000 / $2,800,000). Groups managing A/R well will have net collection
ratios above 95%.
Determine how many months of revenues are outstanding. For example, if net revenues average $300,000 per month, and outstanding A/R is $900,000, then three months of
revenues are outstanding, which is not unusual. If less than three months of revenues are outstanding, the group is doing a good job of collecting. If greater than three months
of revenues are outstanding, the practice may need to focus more effort on A/R management or evaluate its write-off policy. A write-off policy provides management
guidelines concerning when amounts on an account should be considered uncollectable and written-off, or deducted from outstanding A/R. Determine the write-off policy of the
group when evaluating A/R, particularly for amounts that are greater than 90 days old.
Payer Mix Report
A payer mix report is a useful practice management report. While groups may refer to it by other names, it is generally a report that lists the payments to the practice by payer
type, or payer category. For example, the group may be able to summarize payments in the practice management information system by categories such as private pay,
Medicare, Medicaid, PPO, HMO, etc. Most practices have reports that list out each unique payer. Useful assessments of the payer report is to determine and rank the top
payer categories by gross charges billed; top payer categories by payments; and top payer categories by contractual adjustments. These reports provide insight into the
group’s participation in major health plans and the relative importance of each to the group in terms of revenues. An example of a payer mix report is provided in Appendix A,
Choosing a practice opportunity is one of the most important decisions made following medical training. While many factors come into play in reaching a decision, the financial
prospects of the opportunity are usually high in priority. To understand the medium to long term prospects of an opportunity, knowledge regarding group practice financial
concepts and financial performance indicators of a group are vital.
While first and second year offers may be enticing, the medium to long term financial prospects of the opportunity should be critically explored. If a group has extended an
employment offer but is reluctant to share financial and productivity information, a physician candidate might offer to sign a confidentiality agreement to not share the
information with anyone other than advisors for the purposes of assessing the opportunity. If the group remains unwilling to share financial information, it might be
indicative of problems, issues the group would rather not disclose, or a reluctance to share information in general.
Open, honest communication is critical to the success of a group practice; the earlier established the better. While this component of the Tool Kit focused on providing an
introduction to key finance concepts and financial areas to assess, other components of the Tool Kit are equally important in developing an overall assessment of an opportunity.
Exhibit 1 – Balance Sheet
Balance Sheet – Example
CASH $44,847 $44,334
ACCOUNTS RECEIVABLE $684,337 $826,056
ASSETS $729,184 $870,390
FURNITURE, FIXTURES & OFFICE EQUIP $92,809 $102,346
MEDICAL EQUIPMENT $32,525 $29,264
COMPUTER EQUIPMENT $47,359 $51,213
LEASEHOLD IMPROVEMENTS $55,581 $55,581
LESS: ACCUM DEPR ($191,223) ($188,870)
TOTAL FIXED ASSETS $37,051 $49,534
TOTAL ASSETS $766,235 $919,924
LIABILITIES & CAPITAL
PAYROLL TAXES PAYABLE $7,105 $8,711
NOTE PAYABLE – MEDICAL EQUIPMENT $49,045 $31,248
NOTE PAYABLE – COMPUTER EQUIPMENT $16,829 $7,650
NOTE PAYABLE – LINE OF CREDIT $99,900 $69,485
PENSION PLAN PAYALBE $42,624 $47,439
TOTAL CURRENT LIABILITIES $215,502 $164,532
STOCKHOLDER’S EQUITY $550,733 $755,392
TOTAL LIABILITIES & EQUITY $766,235 $919,924
Exhibit 2 – Income Statement
Practice Income Statement – Example
Summary Income Statement
Year Ending Year Ending
Compilation % Inc Compilation % Inc Growth
GROSS CHARGES 4,549,000
Net Medical Service Revenue 2,683,251
Other Income 26,120
TOTAL INCOME 2,709,371
Other Occupancy & Usage 82,381
Purchased Services 70,107
TOTAL OPERATING EXPENSES 1,678,014
NET INCOME 1,031,357
Exhibit 3 – Aging Accounts Receivable
Account Receivable Aging Report – Example
Aged Trial Balance
0-30 Days 411,156
31-60 Days 101,802
61-90 Days 34,939
Total < 90 547,897
91-120 Days 23,647
Over 120 Days 112,793
Total > 90 Days 136,440
TOTAL A / R 684,337
Exhibit 4 – Payer Mix Report
Medicare 52% 54%
HMO/PPO 26% 28%
Commercial 10% 8%
Blue Cross Blue Shield 8% 6%
Medicaid 2% 2%
Cash 2% 2%
Amounts that are due from patients and/or insurance companies for patient services that have been provided.
Accrual Basis Accounting
An accounting method that recognizes revenues in the period that services are provided, not when collection of cash occurs; expenses are recorded in the period when they are
used to generate such revenue. In accrual accounting, the practice attempts to match revenue and related expenses to determine practice profit (accrual accounting is the
opposite of cash accounting).
Aging of Accounts Receivable
The process of classifying accounts receivable (A/R) into categories reflecting the amount of time that has elapsed since the patient and/or insurance company was billed
for the services provided. At any point in time, a practice’s A/R aged since the billing date is either current (less than 30 days), 31-60 days, 61-90 days, 90-120 days or over
Anything of value that is owned by the practice such as accounts receivable, equipment, and furnishings. Current assets are those expected to be turned into cash or sold within
A financial statement that presents the assets, liabilities and Shareholder’s equity of the practice at a particular point in time.
The point where the revenues of the practice and the expenses of the practice are equal. When practice revenues are less than practice expenses, there is an operating loss.
When practice revenues are greater than practice expenses, there is a operating profit.
Amounts available to the practice for investment (see “working capital”), may also be defined as the amounts that have been invested in the practice by the shareholders
Practice cash receipts less practice cash disbursements in a particular period of time.
Cash Basis Accounting
An accounting method that recognizes revenues in the period that cash is collected; expenses are recorded in the period when they are paid. In a cash basis of accounting,
the practice makes no attempt to match revenues with related expenses to determine practice profit (Cash accounting is the opposite of accrual accounting).
Adjustments or discounts taken against billed charges to reflect contractual agreements with insurance companies regarding the amount to be paid for a particular service.
The process of allocating the cost of an asset over its useful life. Depreciation is recorded on the balance sheet.
Financial reports for the practice that are compiled, usually by an accountant, monthly, quarterly and or annually. Financial statements include a balance sheet and income
Refers to the asset category of furniture, fixtures and equipment.
A practice expense that does not directly vary with the volume of services provided (e.g. professional liability expense).
The total services billed by the practice for a given period before any adjustments are made. Once adjustments are made (e.g. contractual allowances and write-offs) gross
charges become net charges, or net revenue on an accrual basis of accounting.
The practice’s cost of borrowing money.
A financial statement that summarizes the practice’s operational results for a specific period of time by reporting the practice’s revenues, expenses and net income. Also
called a profit and loss statement, or simply a P&L.
Amounts that are owed by the practice, recorded on the balance sheet. Current liabilities are those expected to be due within a year. Long-term liabilities are due over a period
greater than one year.
The total services billed (accrual accounting) or collected (cash accounting) by the practice for a given period before after any adjustments (e.g. contractual allowances and
write-offs) have been made.
A profit and loss statement, referring to the income statement.
Refers to the asset category of plant, property and equipment sometimes used in to refer to furniture, fixtures and equipment.
Reports typically generated by the practice management system software that provide gross charges, payments received and contractual adjustments recorded by physician.
A practice expense that directly varies with the volume of services provided (e.g. medical supplies).
Those assets in the practice that are considered current, or in the case of net working capital, current assets less current liabilities.
Financial Assessment Checklist
1. What are the assets and liabilities of the group?
2. Does the group have a line of credit with a bank? Who funds investments?
3. What is the practice’s profitability? That is, what is the net income of the practice before physician salaries and benefits?
4. What is the current year annualized net collections? To annualize, divide the total collections of the latest reported financial period by the number of months in that period and multiply by 12.
5. What is the annual net collection growth rate of the practice over the past 3 years?
6. How have expenses moved in relation to the collections over the past 3 years ?
7. What revenues and expenses are the group budgeting for you in the first year of your practice?
8. What happens if you do not break-even in the first year?
9. Does the practice have a hospital recruiting agreement that will provide a salary and expense guarantee?
10. How does the hospital guarantee work? Who receives the money? Who is responsible for paying back any amounts owed related to the guarantee?
11. What are the total charges, adjustments and collections for each physician?
12. How does the above information translate into the physician’s compensation?
13. Is physician income growing or declining?
14. What are the components of the physician compensation formula?
15. What reports are available to demonstrate the translation of productivity and
profitability to physician compensation?
16. What percentage of the total accounts receivable are current?
17. How many months of collections are in Accounts Receivable? Often referred to as days sales outstanding, or DSO, a lower DSO indicates better management of accounts receivable?
18. What is the volume of services for each CPT code billed by the practice?
19. Based on CPT code data what services are growing?
20. Based on CPT code data what services are declining? Why?
21. Are there services that a new physician can perform that are not currently provided by the group?
22. What are the top 10 health plans in terms of percentage of total charges?
23. What are the top 10 health plans in terms of percentage of total collections?
24. How does #18 compare to #19?
About the Author:
Wesley D. Millican, MBA, CEO and Physician Talent Officer of CareerPhysician Advisors, LP, and CareerPhysician, LLC, provides comprehensive talent solutions for academic children’s hospitals, colleges of medicine and academic medical centers across the nation. He possesses a longstanding passion for career development of all young physicians and serves as a go to career resource for training program directors and their residents and fellows. In continuing his commitment to the “future of medicine”, Mr. Millican speaks nationally at residency and fellowship programs. His Launch Your Career® Series is a proven resource for today’s residents and fellows and has served as a go to resource for program directors over the last 15 years.