Valuing Medical Practices

How much is that receivable really worth?

Valuing receivables in a medical practice is never simply a matter of analyzing an aged receivables report. A number of factors must be considered to accurately value what could easily be the largest asset of the practice.

Is that receivable really collectible?

Do you remember your first accounting class, Debit Accounts Receivable and Credit Revenue? So far, so good!  Debit cash and credit accounts receivable—but wait, there’s still a partial balance left in accounts receivable. With many valuation methods, one needs to determine the fair market value of the underlying assets and liabilities.

This remains true for the valuation of a medical practice.  The fair market value or collectability of the accounts receivables needs to be determined.  How hard can that be? It’s harder than you may think, if you’ve never dealt with accounts receivables generated by a medical practice.

In most other industries, determining the amount of collectible receivables is usually a relatively simple function of reviewing a receivable aged analysis report and/or applying a historical percentage of bad debt to adjust the allowance for uncollectible accounts to proper expectations, which leave us with a fair estimate of the collectible receivables.

What makes this work is the underlying assumption that a $1,000 sale creates a $1,000 receivable that converts to $1,000 cash—paid in full!  In the medical practice industry, that underlying assumption does not hold true! Revenue generators (i.e., doctor services) are generally described as (uniform) billing codes.  The American Medical Association (AMA) publishes a nearly 800-page manual known as Current Procedural Terminology ( CPT^®), which is a listing of descriptive terms and identifying codes for reporting medical services and procedures performed by physicians.

As we will see in a moment, $1,000 of medical service sales creates a $1,000 receivable that usually will never convert to $1,000 cash collection!

In its forward, the CPT¹ presents, in part, the following:

The CPT codebook is the most widely accepted nomenclature for the reporting of physician procedures and services under government and private health insurance programs.  In 2000, the CPT code set was designated by the Department of Health and Human Services as the national coding standard for physicians and other health care professional services and procedures under the Health Insurance Portability and Accountability Act (HIPAA).  This means that for all financial and administrative health care transactions sent electronically, the CPT code set will need to be used.

So here’s what generally happens to that $1,000 medical “sale.”  Think back to the last time you went to the doctor.  You made your co-payment at the cashier and sometime later, you received an Explanation of Benefit (EOB) in the mail from your insurance company.  What?!?  That x-ray cost me $1,000???  No.  One thousand is what the doctor’s office billed your insurance company.  Now, look at two very important numbers: what did your insurance company allow and what is your responsibility?  Let’s say your insurance company allows $200 for the x-ray.  Then, they apply deductibles and co-insurance.  Your responsibility may only be $40 for the x-ray.  Even so, your insurance company will send the remaining $160 back to the doctor, per the contract it holds with him that stipulates he/she will accept this $200 as payment in full.

The physician sets his/her rate for a specific code or procedure.  For example, code 73070 provides for an elbow x-ray. We’ll assume for illustrative purpose that the physician charges $1,000 for this procedure.  Further, assume that Medicare only allows $140 for this procedure and also, that each accepted insurance provider has negotiated its own reimbursement rate with that doctor for that specific procedure, which is always less than the fee structure the doctor chose. 

How does a medical practice book that $1,000 invoice for the x-ray?  Likely, they booked it as a $1,000 receivable.  Each insurance company differs on the contracted rate it will pay the medical office.  The same goes for how much each individual patient pays, as well.  So, the practice will show $1,000 receivable until all the adjustments and responses from the insurance company are received.  Out of several million receivables, what’s collectible?  This would also vary from practice to practice  Generally speaking, the larger the group, the better the negotiating leverage.  How good is the billing department?  Are claims being denied?  Are they being rebilled correctly?  How aggressively are the unpaid accounts pursued for collection purposes?

Consequently, a 90-day outstanding receivable may still have significant value, while a 30-day may not have any value.  This somewhat diminishes the value of an aged receivable analysis; don’t you think? How often does the billing department adjust (write-off) the “never collectible” portion (i.e., $1,000 – $200= $800)?

Let’s work through an oversimplified example of the math.  We’ll assume that elbow x-rays are the only service the physician provides and set the established rate for this procedure at $1,000.  Next,  assume that this physician’s contract with insurance company A allows $600 for this procedure, company B allows $400, company C allows $200 and Medicare allows $140.  For the purposes of this example, the physician  provides no free service (indigent care) and has no bad debts (all accounts are collected to full amount of invoice or contract).  The last assumption is clearly not reality, but will aid in our illustration.  He/she provided the same service to 10 patients as follows:

In this very simplistic example, the physician billed $10,000, collected in full the contracted amount, and had a collection to sales ratio of 50.80 percent!²

This 50.080 percent is commonly referred to as the “gross collection rate.”  Any adjustments in collection for uncollectible accounts (either from bad debts or from disputes with the insurance company) will provide his/her “net” collections.  Then by comparing gross collections (the amount the contracts allow the physician  to collect) to net collections, we wind up with a “net collections rate.”  There are numerous industry publications that provide statistics by medical specialty for each of these ratios.

Now we have a starting point for quantifying/justifying the subject practices’ collection rates.  Once we’re satisfied with our net collection rate for the subject practice, what’s our next consideration?

Having analyzed the subject’s detailed billings/collection reports, we should now have a good feel for what age we can reasonably consider a receivable non-collectible.  For this exercise, we’ll say anything beyond six months is non-collectible.  At this point,  we can determine gross billings for a minimum of six months, apply our net collection/sales ratio and then subtract our collections for those billings.

To illustrate:

The bottom line is that, in a medical practice, net collection rates will vary widely from practice to practice depending on factors such as which insurance companies the practice has contracts with, the makeup of the patient base (indigent, Medicare, private pay, insured), the quality of the billing and coding staff and even the mix of the individual patient insurance plans (deductibles, co-insurance, etc).  The core of accurately valuing the receivables goes back to the fundamentals of valuation theory: know the industry and the business you are valuing.   Take the time to learn about them if you are unfamiliar.

Patrick Dugas, CPA, CVA is owner of Dugas & Associates (www.dugascpa.com) based in Winter Haven, Florida. He has been an active practitioner for nearly 38 years and has servedand has served as an expert in valuation and forensics. Recently, his daughter, Janette, joined the firm.  You can reach Patrick at taxdugas@aol.com.