Just like there are ratios that gauge your patients’ health, there are ratios to gauge the financial health of your practice.
One of the most important ratios to know is a solvency ratio called the current ratio. The current ratio is it very easy and simple calculation to perform. But first, a few definitions are needed. When we say current in a financial report, we are indicating that we can either convert the asset into cash within a one- year period or the liability is due within one year. Current assets are assets we can convert to cash within one year. Current assets are cash, cash equivalents, accounts receivable (A/R),bad debt allowance, and any inventory we have on hand. Current liabilities are bills that must be paid within one year. Current liabilities are all notes and accounts payable due within one year, interest payable, wages payable, and the income taxes payable.
The current ratio is an indication of the firm's ability to pay back its short-term liabilities. To obtain this ratio, we take all of the current assets and divide them by the current liabilities. If the current ratio is less than one, this indicates the company has more debt due within one year than it has assets it can use to pay those debts. This is a critical ratio for any company, particularly in medical practice. If your current ratio is less than one, you need to seriously consider how your practice will survive should something happened to your cash flow.
Another ratio similar to the current ratio is the Quick Ratio (or Acid-Test). This is the same as a current ratio, except that inventories are not included in the numerator. It looks at the most liquid assets and compares them against the current liabilities. If your practice does not hold inventory then your current ratio is a quick ratio or acid test.
Days in A/R measure a company’s ability to convert receivables into cash. A low “Days in A/R” indicates that the practice can quickly collect on its debts. This ratio varies from industry to industry. The important thing to watch is if the number increases or not. If it is increasing, it should spurn your staff to investigate the reason why and find ways to bring the number back down. Every practice should know their general days in A/R. It is also equally important to know the days in A/R for each payer class. How long does it take for CMS to pay you? How long does it take for commercial payers to pay you? How long does it take to get paid from patients with health savings accounts? These are all very important questions that can help you make better decisions and plan for the future. The calculation is performed by dividing accounts receivable by the revenue and then multiplying by 365.
Operating margin is a measure of what proportion of the company's revenue is left over after paying for the variable costs of production of the services or goods. These costs include wages, raw materials, etc. It is important to have healthy operating margin so that the company has enough cash to pay for its fixed costs. This is also known as an operating profit margin for the net profit margin. It is calculated by dividing the operating income by the net revenue.
Capital measures the firm's abilities to pay its bills on time. It is another liquidity or solvency ratio. It is calculated by subtracting the current liabilities from the current assets. The larger the number, the larger the working capital and the "larger" the cushion the firm has should an unexpected downturn in revenue occur.
Like days in accounts receivable, “Days in Accounts Payable” (A/P) measures how long it takes for the practice to pay its bills. This is an important ratio because it can be a lagging indicator a financial health and solvency of the practice. Also, it can be a good indicator of how well the practice is using its cash. Paying bills too soon might strap the firm for cash in the short-term. Paying bills too late puts the practice in jeopardy for other financial and legal action. This is also a good ratio for you to know about those with whom you have service contracts or agreements. If they take a long time to pay their bills, it will give you an indication of what to expect. This calculation is made by the ending accounts payable divided by the cost of sales divided by number of days.
As physicians we are quite familiar with methods in discovering the health of our patients. We use measures such as HDL:LDL ratio, waist to height, waist to hip, and many other measurements to determine the health of our patients. In fact, we’re pretty good at it. We can even use this data to predict what problems the patients will face and even how long they might live.
Did you know there are similar ratios and methods that accountants and business leaders use to determine the financial health of a company? These ratios can tell you the financial health of your practice. I’ve listed the top five financial metrics that every physician should know and use every month.
These are just a few the financial ratios physicians can perform using the income statements and balance sheets provided to them by their accountants and office managers. These ratios will help you determine the level of financial stability of your practice and help you make better decisions for your future. Financial health is hard work. Just like we ask our patients to keep track of their diet and exercise activity, we should also closely monitor the financial health of our practices. We must be diligent actively manage our business.
About the Author
David Norris, MD, MBA is an anesthesiologist at Wichita Anesthesiology Chartered in Wichita, Kansas and also with the Center for Professional Business Development