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This article is presented in two parts. Part I, in our October issue, dealt with sources of benchmarking data. Part II, presented here, covers benchmarking a subject entity’s data against the industry.
I. Benchmarking the Subject Entity’S Data Against the Industry
Benchmarking a medical practice’s financial data against industry averages and norms typically includes the following steps:
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Select the appropriate survey to use as a benchmark. Ask this question: “In which surveys would the subject entity most likely be included?”
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If necessary, recategorize the subject entity’s revenue and expense accounts and align them to the selected survey’s structure and definitions.
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Calculate variances from industry averages and norms and express them either as percentages or in terms of ratios or dollar unit amounts.
I.A. Usefulness in Valuation Engagements
Valuators often use benchmarking to help assess a subject entity’s risk by identifying and quantifying its relative strengths and weaknesses compared to similar entities in its industry. Common methods of applying benchmarking analyses to the valuation process include:
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Adjusting operating expense and capital items as well as capital structure to industry norms (when valuing a control position).
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Adjusting to the indication of a discount rate or cost of equity derived from the market (subject entity specific risk premium).
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Selecting appropriate financial multiples or ratios (e.g., price/earnings, price/revenue,
price/EBITDA).
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Selecting appropriate discounts and premiums based on the level of value sought (e.g., discount for lack of marketability, control premium, minority discount).
As mentioned above, benchmarking a health care entity’s financial data against industry averages and norms can be categorized as either financial ratio analysis or operational performance benchmarking. Each is illustrated below with benchmarking samples.
I.B. Sample Financial Ratio Analysis
Financial status benchmarking involves the development and use of ratios to allow a comparative analysis. The selected ratios may provide indicators of several measures of the subject entity’s operating performance or financial condition. Common types of financial indicators measured by ratio analysis include:
Liquidity. Liquidity ratios measure the subject entity’s ability to meet cash obligations as they become due, i.e., to support its operational goals. Ratios above the industry mean generally indicate that the subject entity is in a stronger position to support these immediate goals. The current ratio reflects the subject entity’s ability to meet short-term obligations. Managers use the current ratio, which quantifies the relationship between assets and liabilities, to determine how quickly assets are converted into cash.
Activity. Activity ratios indicate how efficiently the subject entity uses its resources (assets). Also called efficiency ratios, these ratios indicate how well the subject entity manages assets, including cash, accounts receivable, salaries, inventory, property, plant, and equipment. Lower ratios may signal inefficient use of those assets.
Leverage. Leverage ratios illustrate the proportion of funds, or capital, provided by shareholders (owners) and creditors. These ratios help valuators determine if the subject entity has too little, too much, or an appropriate level of debt. Leverage is often measured by the ratio of long-term debt to net fixed assets. A ratio equal to or below the industry norm is generally viewed as a sign that the subject entity does not exhibit heightened risk concerns.
Profitability. Profitability ratios reflect the overall net effect of the subject entity’s managerial efficiency. High payroll and additional costs may significantly contribute to the lack of profitability in a health care entity. In determining a subject entity’s profitability for benchmarking purposes, the analyst should first review owner compensation, making adjustments if appropriate. To arrive at an “economic level” of profit for a medical practice, it’s very important to adjust for the market value of the “replacement cost” of professional services provided by the
owner(s).
Selecting financial ratios for analysis and comparison to the subject entity’s performance requires careful attention to data homogeneity. Benchmarking of intraorganizational data typically provides similar data across various measurement periods. But many organizations seek data from several external facilities for comparison. Using a standard chart of accounts for the subject entity, such as the one developed by MGMA, or recasting the subject entity’s data to that format, can facilitate comparison of the subject entity’s operating performance and financial status data to survey results.
The following tables provide a sample benchmarking analysis exercise related to a four-cardiologist medical practice (the “CD Practice”).
Table 17, below, compares certain aspects of the CD Practice’s historical performance and financial position as measured by financial ratios and compared against ratios developed from two industry survey data sources: “Financial Studies of the Small Business”(FSSB), published by Financial Research Associates, and “Annual Statement Studies,” published by Risk Management Associates, f/k/a Robert Morris Associates.
Table 17: Financial Ratio Analysis
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FSSB (1)
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RMA (2)
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subject entity CD PRACTICE
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Upper
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Lower
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Upper
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Lower
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Quartile
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Median
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Quartile
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Quartile
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Median
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Quartile
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12/31/1998
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Liquidity Ratios
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1
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Current Ratio
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4.1
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1.1
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0.3
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1.7
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0.6
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0.1
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1.03
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2
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Quick Ratio
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4.1
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1.1
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0.3
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1.5
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0.5
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0.1
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1.03
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Activity Ratios
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3
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Sales/Receivables
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6.7
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0
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0
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N/A
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10.0
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N/A
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5.42
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4
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Sales/Net Fixed Assets
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N/A
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N/A
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N/A
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48.1
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18.7
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6.6
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14.47
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5
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Sales/Total Assets
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16.9
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8.6
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3.8
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14.2
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5.7
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2.1
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3.83
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Leverage Ratios
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6
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Fixed/Worth
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N/A
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N/A
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N/A
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0.6
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2.6
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3.7
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0.92
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7
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Debt/Worth
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0
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0.29
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1.38
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1.1
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5.7
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6.6
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2.48
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Profitability Ratios
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8
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Profits (Pretax)/Total
Assets (%)
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1.08
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0.13
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-0.01
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24.6
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3.8
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-3.4
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0.02
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9
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Profits (Pretax)/Net
Worth ($)
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1.60
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0.21
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-0.03
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101.2
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20.8
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-1.0
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0.08
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Notes:
1. Source: “Physician Services” Financial Research Associates “Financial Studies of the Small Business 20th
Edition” (1997-1998 – All Sizes)
2. Source: SIC Code #8011 (Offices and Clinics of Doctors of Medicine) Risk Management Association
“Annual Statement Studies” (all statements4/1/98-3/31/99)
N/A = Not Available or Not Applicable
I.C. Sample Operational Performance Benchmarking Analysis
Using the CD Practice’s most recent income statement and balance sheet, as set forth below in Tables 18 and 20, respectively, we illustrate several methods of benchmarking the CD Practice’s operational performance and financial status.
Table 18: Financial Statement of the Subject CD Practice
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subject entity
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REVENUES
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1998 (3)
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1
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TOTAL NET REVENUE
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$3,884,098
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OPERATING EXPENSES,
NON-MD OWNER COMPENSATION
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2
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Staff Payroll &
Payroll Taxes
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$971,025
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3
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Advertising &
Marketing
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$11,652
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4
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Ancillary Expense
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$77,682
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5
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Equipment Expense
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$77,682
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6
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Insurance – Liability
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$7,768
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7
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Insurance – Malpractice
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$46,609
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8
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Professional Fees
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$62,146
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9
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Medical Supplies
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$54,377
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10
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Occupancy Expense
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$213,625
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11
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Office Supplies and
Services
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$139,828
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12
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Miscellaneous
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$155,364
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13
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Total Operating Expenses
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$1,817,758
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MD OWNER COMPENSATION
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14
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Total Physician
Compensation
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$2,042,026
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15
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Net Income before Taxes
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$24,314
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I.C.1. Comparing Income Statement to Industry Averages
CD Practice’s income statement was compared against industry norms, represented by data derived from the two benchmarking data sources. Often, it’s appropriate to use multiple benchmarking data sources, which, under certain circumstances, can support a range of indicators to which the CD Practice can be compared.
Table 19: Benchmark Comparison of the CD Practice’s Income Statement to Industry Norms
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Industry
Survey #1
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Industry
Survey #2
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subject entity
CD PRACTICE
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REVENUES
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MGMA (1)
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NAHC (2)
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1998 (3)
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1
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TOTAL REVENUES
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100.0%
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100.0%
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100.0%
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OPERATING EXPENSES,
NON-MD OWNER COMPENSATION
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2
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Staff Payroll &
Payroll Taxes
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21.9%
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21.8%
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(9)
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25.0%
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3
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Advertising &
Marketing
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0.4%
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0.2%
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0.3%
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4
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Ancillary Expense
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4.5%
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(4)
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0.3%
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(10)
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2.0%
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5
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Equipment Expense
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1.4%
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2.6%
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2.0%
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6
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Insurance - Liability
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0.2%
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0.4%
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0.2%
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7
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Insurance - Malpractice
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1.2%
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1.5%
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1.2%
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8
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Professional Fees
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1.1%
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2.2%
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1.6%
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9
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Medical Supplies
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1.0%
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3.2%
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1.4%
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10
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Occupancy Expense
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4.1%
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3.8%
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5.5%
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11
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Office Supplies and
Services
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2.8%
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(5)
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3.6%
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(11)
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3.6%
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12
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Miscellaneous
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4.3%
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(6)
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3.0%
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(12)
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4.0%
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13
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Total Operating Expenses
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42.9%
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(7)
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42.6%
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(13)
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46.8%
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14
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Operating Margin
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57.1%
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(8)
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57.4%
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(14)
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53.2%
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(15)
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Notes:
1. Source: Medical Group Management Association (MGMA) 1999 Cost Survey (Based on 1998 Data) Table 10-56 : Operating Cost – Median reported data “Total Support Staff Cost” – Cardiology. Pg. 134.
2. Source: National Association of Healthcare Consultants (NAH), The PM Group, and Society of Medical-Dental Management Consultants “Statistics: Medical and Dental Income and Expense Averages 1999 Report (Based on 1998 Data) – Mean reported data - Cardiology (All Regions). Pg. 23.
3. Source: subject entity’s 1998 audited income statement
4. Includes clinical laboratory, radiology/imaging and other ancillary expenses
5. Includes administrative supplies and services and information services
6. Includes miscellaneous operating cost (2.0%) and variance between survey total operating cost and sum of survey breakdown (2.3%)
7. Total Operating Cost as reported by survey
8. Total Revenue less Operating Expenses
9. Includes total salaries, fringe benefits, retirement and payroll taxes
10. Includes laboratory expenses only
11. Includes clerical supplies, telephone, billing service, dues and education.
12. Includes other expenses (1.8%), other taxes(.5%) and variance between survey total operating cost and sum of survey breakdown (.7%)
13. Total Overhead Expense as reported by survey
14. Total Revenue less Operating Expenses
15. Total Revenue less Operating Expenses
The above analysis (Table 19) of the CD Practice’s income statement indicates that it has a higher-than-average payroll compared to industry survey norms. This may prompt the valuator to determine the cause for above-average payroll costs. Several causes may present themselves, including:
Low turnover.
High employee turnover is common in medical practices. In a practice with low staff turnover, payroll tends to be higher than industry norms.
Family or friends on staff.
It’s not uncommon for an owner-physician’s family members or friends to be on staff. The valuator should determine if their services are reimbursed at fair market value and make adjustments if appropriate. There are many salary and compensation surveys available to assist the valuator in determining fair market salaries.
The analysis also indicates that CD Practice’s occupancy cost is higher than the industry average. One of the most common reasons for high occupancy costs in a medical practice is the common ownership of both the practice and the office building. The owner-physicians of the practice may own the office building through a separate company and set rent at a level that provides tax-related benefits. In those circumstances, the analyst should review the lease to determine if the rent paid by the subject practice is fair market rent relative to the area, and, if not, consider adjustments to reflect “economic” rather than “contract” rent.
The indications of above average staffing and occupancy costs of the CD PRACTICE significantly contribute to its above average operating costs, or overhead. A valuator may take these high overhead costs of the subject CD PRACTICE into consideration when determining the subject entity risk and adjustment that would reflect the perception of a typical, knowledgeable investor.
I.C.2. Comparing Balance Sheet to Industry Averages
The CD Practice’s balance sheet (see Table 20) was compared against industry survey data derived from two well-known industry benchmarking data sources (see Table 21), RMA and MGMA. This balance sheet analysis indicates that the practice has a higher portion of total assets in accounts receivable than the industry norm. This may indicate the existence of uncollectible accounts that haven’t been addressed in the claims resolution process of the practice’s revenue cycle. Leaving these amounts unadjusted could contribute to above-average shareholders’ equity, which the valuator should investigate to determine the cause.
Possible causes include:
Contractual discounts and adjustments.
Many medical practices have provider service agreements with third-party payors that reimburse professional medical services on a discounted fee-for-service basis. While the full charge for the service is placed in accounts receivable once it’s billed, the discounted or nonreimbursable portion of the charge may not be entered into the practice’s billing system when it receives the explanation of benefits (EOB) from the insurance company or managed care organization (MCO). These amounts remain in the practice’s accounts receivable indefinitely, and distorting the practice’s financial condition. The analyst may review the accounts receivable aging as a quick check to determine if this condition exists.
Payor mix.
Reimbursement from certain payors, such as workers’ compensation and related litigation cases, can take years to collect. In addition, it’s often more difficult to collect accounts from self-pay patients than from government payors. The analyst may review CD Practice’s payor mix and its collections history for various payor classifications, such as the percentage of patient self-pay receivables that have historically been collected. Certain adjustments may be needed to better reflect the economic value of accounts receivable.
Table 20: Balance Sheet of the Subject Entity
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subject entity
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12/31/1998
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ASSETS:
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Current Assets:
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1
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Cash
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$26,335
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2
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Accounts Receivable
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$717,115
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3
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Other Current Assets
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$1,013
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4
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Total Current Assets
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$744,462
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5
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Total Net Fixed and Non-Current Assets
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$268,412
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6
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TOTAL ASSETS
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$1,012,874
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LIABILITIES:
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7
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Total Current Liabilities
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$514,540
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8
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Total Long Term Liabilities:
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$207,639
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9
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Total Liabilities
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$722,179
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10
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Total Shareholders' Equity
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$290,695
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11
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TOTAL LIABILITIES
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& SHAREHOLDERS' EQUITY
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$1,012,874
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Table 21: Benchmark Comparison of the subject entity’s Balance Sheet to Industry Averages
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Industry
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subject entity
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ASSETS:
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RMA (1)
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12/31/1998
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Current Assets:
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1
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Cash
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19.0%
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2.6%
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2
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Accounts Receivable
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14.3%
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70.8%
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3
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Other Current Assets
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3.3%
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0.1%
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4
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Total Current Assets
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36.6%
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73.5%
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5
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Total Net Fixed and Non-Current Assets
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63.4%
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26.5%
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6
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TOTAL ASSETS
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100.0%
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100.0%
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LIABILITIES:
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7
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Total Current Liabilities
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70.7%
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50.8%
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8
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Total Long Term Liabilities:
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37.3%
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20.5%
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9
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Total Liabilities
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108.0%
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71.3%
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10
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Total Shareholders' Equity
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-8.0%
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28.7%
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11
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TOTAL LIABILITIES & SHAREHOLDERS' EQUITY
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100.0%
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100.0%
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Notes:
1. Source: SIC Code #8011 Risk Management Association “Annual Statement Studies”, 2000, 2001 (all statements 4/1/98-3/31/99)
I.C.3. Comparing Accounts Receivable Aging to Industry Averages
The analysis of CD Practice’s accounts receivable aging (see Table 22 below) indicates that a large portion of accounts receivables is more than 120 days old. The analyst should review CD Practice’s policy on treatment of uncollectible accounts and make adjustments if appropriate.
Table 22: Benchmark Comparison of Accounts Receivable Aging to Industry Averages
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Current
(0-30
Days)
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31-60
Days
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61-90
Days
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91-120
Days
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120+
Days
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1
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CD
PRACTICE
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46.6%
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9.2%
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7.4%
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4.8%
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32.0%
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2
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INDUSTRY
AVERAGE (1)
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45.6%
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15.8%
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8.4%
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5.5%
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23.9%
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Notes:
1. Source: Medical Group Management Association (MGMA) 1999 Cost Survey (Single Specialty – Cardiology - Median)
I.C.4. Comparing Payor Mix to Industry Averages
CD Practice’s payor mix was compared against industry norms (See Table 23). Other than having a slightly higher amount of commercial and self-pay patients (which may have contributed to higher accounts receivable), CD Practice’s payor mix is generally in-line with the industry.
Table 23: Benchmark Comparison of subject entity Payor Mix (%) to Industry Averages
Notes:
1. Source: Medical Group Management Association (MGMA) 1999 Cost Survey (Single Specialty – Cardiology - Median)
I.C.5. Comparing Physician Productivity to Industry Averages
A review and analysis of the CD PRACTICE’s financial statements should also consider the productivity and utilization of the physicians that its revenue and income. Both the MGMA “Cost Survey” and the AMGA “Survey of Key Medical Management Information” provide data provider productivity on the basis of the full-time equivalency (FTE) of physician involvement in practice-related activities, as well as on a per-Relative-Value-Unit (RVU) basis.
These measures allow the analyst to normalize the practice’s data for comparison to industry norms. Calculating values on a per-FTE physician basis recognizes that physicians drive both revenues and expenses. This approach allows for meaningful benchmarking of these operating performance measures. Reporting the data on a per-RVU basis provides a means of normalizing expenses based on the amount of physician work, overhead, and insurance costs (the components of RVUs) that are required to complete medical procedures. This is used to remove the bias of reimbursement yield disparity from the comparison of physician productivity.
Comparing the CD Practice’s physician productivity to industry norms (See Table 24) indicates that the practice’s physicians provide more services in settings outside the office than the norm reported by cardiologists. This is evidenced further by the fact that the CD Practice’s physicians performed more work providing more RVUs than the industry mean. This may indicate that the more complicated procedures they prefer require a hospital or ambulatory care facility for patient treatment.
Table 24: Benchmark Comparison of Physician Productivity to Industry Averages
Notes:
1. Source: American Medical Association (AMA) 1997/98 Physician Marketplace Statistics (Cardiovascular Diseases – Mean)
2. Source: Medical Group Management Association (MGMA) 1999 Cost Survey (Single Specialty – Cardiology - Median)
3. Per FTE physician
I.D. Summary of Sample Benchmarking
The purpose of benchmarking is to facilitate the valuator’s efforts to identify and explain the subject entity’s variances from the norm. An analysis of these variances can assist the analyst in identifying risk factors and suggesting adjustments to the rate of return that might be required by a typical investor in the subject entity. Keep in mind that using benchmarking results and incorporating them into a valuation model may vary depending on the valuator’s informed, but ultimately subjective, determination of their relevance to the standard and premise of value, the purpose and use of the valuation, and the level of value sought.
II. SUMMARY
In today’s ever-changing, increasingly competitive, regulatory-burdened, and reimbursement-challenged health care delivery environment, health care enterprises that disregard the benefits of regularly conducting operational performance and financial analysis benchmarking risk poor performance and even failure. There are important distinctions between the traditional roles of financial accounting, which records and reports quantitative historical information, and financial analysis, which provides decision methodologies for assessing, predicting, and effecting future performance.
Financial benchmarking is among the more effective techniques for extracting information from a health care enterprise’s historical operating performance and presenting it in a form that facilitates informed judgments that help predict the subject entity’s future operating performance and financial condition.
In the end, a valuator’s use of financial ratios and benchmarking is critical to understanding an entity’s overall historical performance and to the forecasting function of valuation analysis. Serving as a proxy for the “typical investor,” the valuator helps determine the relative risk of investing in the enterprise and predicts the likelihood it will generate future economic benefits for those investors should they participate in the “hypothetical transaction” envisioned in the definition of fair market value.
In this increasingly competitive healthcare delivery environment, the manner in which financial benchmarking ratios are developed, as well as how they are presented and used, may well be the deciding factors as to the valuation report’s ability to convey to readers how the subject entity manages its resources, positions itself to seize opportunities, and is able to adopt and pursue winning strategies for the future. Each of these aspects of the subject entity is central to the investor’s perception of the existence and quantification of its economic value.
Robert James Cimasi, ASA, CBA, AVA, FCBI, CM&A, CMP, President of HEALTH CAPITAL CONSULTANTS (HCC), a health care economic and financial consulting firm serving clients in over 45 states is a nationally recognized author, speaker, and teacher on health care valuation topics. He may be reached at (800) FYI-VALU [394-8258] or by e-mail at rcimasi@healthcapital.com. Mr. Cimasi’s curriculum vitae may be found at www.healthcapital.com/cimasi.htm
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