Physician practice transactions can be challenging from a financial due diligence perspective given the general lack of a finance / accounting function within practices and the cash-basis nature of many practice financials. It is important to understand key financial issues that are common throughout many physician practices, regardless of specialty.
Key items to consider when evaluating physician practice transactions
- Cash to accrual conversion– As most physician practices typically operate on a cash basis of accounting, a standard component of a quality of earnings analysis includes converting the Company’s books from cash to accrual basis. This conversion would consider items such as: accounts receivable, supplies inventory, accrued payroll, and accounts payable. While the most significant part of this cash to accrual conversion relates to accounts receivable and accrued provider compensation (both discussed in below sections), it is also important to understand the historical supplies inventory balances, unaccrued non-provider compensation, and other operating payables when evaluating the working capital necessary to operate the practice.
2. Quality of revenue analysis– In order to estimate historical accounts receivable, a cash waterfall analysis will need to be performed utilizing the Target’s historical claims and payment data. This analysis will present historical cash collections by date of service, which will allow you to analyze collections trends over time and anticipate any future collections. Performing this analysis at a disaggregated level (e.g., by location, provider, payor, procedure, etc.) will allow you to identify trends and anomalies that otherwise may not be apparent when analyzing the cash waterfall on a consolidated basis. Items that may become apparent when analyzing the waterfall on a disaggregated level could include changes in the chargemaster, changes in payor rates, and periods of disruptions in service/billing. If anomalies such as these are identified, the cash waterfall analysis may need to be adjusted to normalize the impact of these outliers. When analyzing the results of the cash waterfall analysis, it is important to understand the trending of charges and payments over the historical period (e.g., increases in volume of charges typically result in a positive cash to accrual EBITDA adjustment).
3. Provider compensation– It is common practice for providers to be compensated based on a production basis (i.e., based on a percentage of collections for services rendered). Based on the results of the provider-disaggregated waterfall analysis and the terms of the provider employment agreements, this production-based compensation can be recomputed on an accrual basis as part of a quality of earnings analysis. It is important to understand the Target’s historical production-based payment schedule. If there is a significant lag between when the compensation is earned (i.e., when the service is performed) and when the compensation is paid to the provider, there could be a significant exposure related to earned but unpaid provider compensation.
4. Owner compensation– The terms of owner compensation are typically renegotiated as part of a potential transaction. As owners may receive the majority of their historical compensation through equity distributions (i.e., no income statement impact), the revaluation of owner compensation (to a production-based arrangement as discussed in the section above) generally results in a significant reduction to the historical reported EBITDA of the physician practice. Conversely, if the owners’ historical compensation has been through payroll (i.e., impact to the income statement), the revaluation of post-transaction close owner compensation may result in a meaningful decrease in payroll expense and an increase in pro forma EBITDA of the physician practice. It is important to consider the terms of the post-close employment arrangement with the owner and the impact of that pro forma compensation when building your investment model.
Overall, the financial due diligence of physician practices could prove challenging given the general cash basis nature of accounting. However, understanding the key issues and analyses needed to address these issues will help ensure a successful transaction.