Which is Better - Profits or Cash Flow?

Many practitioner-owners wonder, "what financial performance measures should I focus on? Profit or cash flow?" As any good business intermediary will tell you, both. Below we explore what to focus on and in what circumstances.

Profits Defined

The American Institute of Certified Public Accountants (AICPA) does not have a specific definition of profit. It generally views profit as the condition when a practice's gross billings exceed its costs. Costs include all expenses associated with running the practice to generate the gross billings. Costs include operating expenses such as physicians' salaries, staff payroll, payroll taxes, rent, supplies, equipment leasing charges, malpractice insurance, advertising and promotions, and the like. Practice costs also include non-operating expenses such as interest charges, depreciation, amortization, and loss on the sale of equipment. Net profit and profit are sometimes interchangeably used. Subtract the practice's income taxes to determine the net profit after taxes.

Cash Flow Defined

Cash flow measures the movement of cash through the practice. Timing is important in measuring cash flow. Cash flow measures the practice's cash balance performance at the beginning of, during, and after events occur in the practice. Is there a cash balance surplus or deficit as a result of an event? And when does that surplus of deficit occur? Cash flow analysis focuses on sources and uses of the practice's cash.

Matters Requiring Focus of Profits

1. Pricing Decisions. Compare, by CPT codes, gross billings and the direct costs of providing those services (e.g., provider time and supplies). This is the contribution margin. The contribution margin measures how much profit (e.g., margin) is contributing to covering the practice's indirect cost (e.g., rent, administrative costs, malpractice insurance). The ideal contribution margin for a medical office varies widely (due to degree of speciality, location). However, an ideal contribution margin for a general practice is 60% or better. Because most prices are determined by insurance contracts or regulation, services that generate less that ideal contribution margins should be scrutinized.

2. Investment Decisions. Pricing analysis helps in making decisions regarding the purchase of expensive equipment. For example, if you are considering whether to buy equipment for lab work, you will want to compare the contribution margin for providing the lab services to the costs or purchasing and maintaining that equipment. How long will it take to recoup your original investment? Is it more profitable to send out the lab work or to provide the services in house? Use the useful life or life expectancy of the equipment as the measurement period.

3. Minimizing Tax Burden. Your CPA and tax advisor can help the practice minimize its tax burden by using profit analysis. CPAs use cost approaches to capture the "true" or "full cost" to operate your practice. They use techniques such as depreciation methods and amortization schedules to present a more complete view of the costs of operating the practice. For example, in our lab equipment example above, they may use an accelerated depreciation method when filing the practice's taxes. These techniques lessen the tax burden on the practice.

Matters Requiring Focus on Cash Flow

1. Practice Liquidity. Practice liquidity measure the ability of the practice to timely pay its obligation when they come due. Does the practice have sufficient cash in the bank to pay the staff on payday? Will the rent check bounce when the landlord deposits it in his bank account? Are you collecting your insurance reimbursement receivables in time to help pay your bill? If you pay your staff every two weeks but you collect your insurance receivables in 30 to 45 days, you may be experiencing a cash squeeze. Should you change the frequency on paying your staff?

2. Debt Service. Banks calculate a debt service coverage ratio (DSCR). DSCR measure how much cushion your practice has compared to its obligation to pay the bank. Banks typically look at the annual cash flow performance of a practice. Compared to the annual principal and interest payments, they ask, "what is the margin of safety (DSCR) for our loan to this practice?" If the margin is less that 20% (i.e., DSCR divided by Annual Principal and Interest Payment is less that 1.20), the practice may be in technical loan default. Check your loan covenants.

3. Value of Practice. In the valuation world, cash flow is king. Buyers are purchasing the future cash flow streams of the practice, not its future profits. Valuations are investor assessments of the practice's attractiveness as a cash generating venture. Similar to the investment decision-making under the Pricing section above, investors are analyzing the excess cash flow the practice generates compared to the risk associated with those cash flows. Is the practice particularly attractive because of its location? Because of the client demographics? Because of the market niche the practice serves? The more favorable these conditions, the higher the probability that the future cash flows will be attractive to buyers. And, in turn, the higher the market valuation of the practice.
   

Profit analysis can assist the practice-owner in optimizing prices, deciding on equipment purchases, and reducing the practice's tax burden. Cash flow analysis helps the practice-owner timely pay the practices bills and debts. Buyers rely upon cash flow to determine the practice's value and what offer price to make.