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Keys to debt management

By David H. Glusman, CPA

In order to understand where your money is coming from and where it is going, especially with regard to the debt of your practice, there are several aspects that need to be reviewed and understood. In order to fully understand your debt, you need to understand where the debt has come from. There are many good reasons for undertaking debt, as well as some reasons that are probably not worthwhile. When debt is undertaken to acquire long-term assets such as machinery, equipment and a building, or to start a new practice, those are usually well thought-out issues. When debt is undertaken for the purpose of temporarily meeting a short-term expense such as a malpractice bill that may come due January 1st, that may also be well thought out. When debt is constantly increasing over a period of time without an increase in assets, and without a specific plan to pay it off, that can lead to financial difficulties and ultimately financial disaster.

The first thing that many practices need to do in order to understand whether their debt is properly managed is to perform a cash flow analysis. In order to understand cash flow, all the areas of the practice should be analyzed. Essentially, you are performing projections for the next several years. The length of time over which the projections will be run will be approximately equivalent to the length of time that the debt is expected to be in place. Generally a five-year time period is a good ball park for running projections.

In order to run projections, you need to have underlying assumptions. In looking at the practice financial statements, and this is the best place to start, take a look at each line item of the income statement, and understand what is likely to change over the forthcoming years. Sometimes it is appropriate to do projections on a monthly period for at least one year to understand the cyclical nature of the practice. Items like malpractice insurance may be paid on January 1st, but may cover the entire year. Other items may cover a quarter, six months, or even periods in excess of a year. Understanding the cash flow cycle with each of these significant expenses will help you understand how to best lay out your debt. In doing this you will also come to a good understanding of the nature of your debt during the year, which will be very helpful in discussing your needs with your banker or other lender.

After taking into account your basic income over the preceding year, it is important to understand your revenue sources. For many practices, Medicare and a few large insurance companies may encompass substantially all of your revenue. In other practices, your revenue sources may be more broadly divided (eight or ten insurance carriers may encompass 80 percent of your revenue). In any event, it is important to understand where your practice is going, and what changes you may be making. If you take your revenue sources down to a reasonable level such that you can understand your revenue flow, you can be in a better position to estimate your revenue going forward. For example, in orthopedic surgery, recognizing that 50 percent of your revenue is coming from Medicare and that your practice is in an area where the population is actually getting younger with younger families moving in, you may find that the Medicare proportion of your practice is going to decline over the succeeding years. In addition, this may give you other thought processes with regard to the type of staff you may need (more sports medicine, less hip replacement). Taking this information together with the other income items, as well as the various expenses will put you in a position of understanding the likely income over the succeeding five years, year by year. You can use this to understand your basic cash flow.

If this hypothetical orthopedic practice is now in need of a new piece of X-ray equipment with a cost of $250,000, they can then understand where the changes in their practice, practice revenue and related expenses will occur. They will also be able to understand the type of debt that they can expect to absorb over the time period. If this new piece of X-ray equipment is going to entail the hiring of a new X-ray technician, the purchase of various X-ray supplies, including the possibility of a computerized storage system, the number and type of X-rays that are expected to be taken can then be projected, along with the income and related expense categories. When all of this is done section by section for the practice, this information can be put together in a concise package that both gives the practice owners and administrators the information to understand the debt, as well as providing a presentation format to a banker that shows that the business (practice) has a full understanding of the obligation they are undertaking.

When running this type of projection, it is important to understand that both interest and principal are going to be repaid, and that the practice (if the debt is being undertaken on other than a fixed-interest basis) may have to anticipate the possibility of interest rate increases occurring during the term of the loan. Various levels of sensitivity analyses may be run in order to understand whether the practice is going to be in jeopardy if interest rates increase above (say) eight percent. Sensitivity analyses will demonstrate the impact of selected changes in assumptions.

The completion of the package will be the detailed written assumptions that are being made. These assumptions will be an integral part of the internal evaluation of whether all aspects of the cash flow of the practice are properly being addressed, as well as the presentation to the lender.

Loans that are taken to simply cover up problems that exist in a practice are generally not considered good management. When physicians are operating their practice at a “loss,” by taking compensation for the owners in excess of the earnings of the practice (and hiding the problem by borrowing to maintain their living standard) this can create major problems and is generally considered to be indicative of a lack of good management in a medical practice. If there are temporary issues that are very likely to be reversed in relatively short order (three to six months is generally the maximum timeframe for this consideration) it may make sense to temporarily borrow money to retain the level of the practice. However, it is often more desirable for the physician owners to reduce their compensation somewhat, on a temporary basis, if temporary problems exist in a practice. If this absolutely cannot be done, it also may be an appropriate consideration for any borrowing to be done at the personal level, not putting an additional burden on the practice for the repayment of the loan as well as the interest. This will vary tremendously based on the size of the practice and the ownership structure.

In summary, debt by itself is not automatically a good or bad thing, but rather, the type of debt, the reason for incurring it, as well as the ability of the practice to pay it off all roll together to understand debt management.

David H. Glusman, CPA, is a principal at Margolis & Company P.C. and is co-chair of the firm’s Healthcare Services Group.

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