Published 11/1/2014

Five Financial Concepts to Understand

Tips from an AAOS Practice Management Primer

Finance isn’t a required course for medical school or residency. But understanding financial concepts is important for orthopaedic surgeons to succeed in private practice. Even orthopaedic surgeons who practice in academic medical centers, hospitals, or groups large enough to hire financial managers need to understand some basic financial concepts so they can make informed decisions.

The following information is adapted from the AAOS Practice Management Primer Enhancing Your Practice’s Revenue: Pearls and Pitfalls. The complete primer can be downloaded from the AAOS Practice Management Center at www.aaos.org/pracman

Financial statements and budgets
It is of crucial importance for the owner(s) of any business to understand how their business is performing from a financial standpoint. This involves, at a minimum, learning about the following three major financial statements:

  • the profit and loss (P&L) statement
  • the balance sheet
  • the statement of sources and uses of cash

In addition, owners need to understand what is involved in developing capital and operating budgets every year and how to compare actual results against budgets. This is a tool that allows business owners and administrators to identify problems before they become serious. Examples of financial statements are available in the AAOS online Practice Management Center. Remember, just five expenses (salaries, benefits, occupancy, supplies, and professional liability) constitute more than three quarters of the typical orthopaedist’s operating costs, and operating costs now account for more than half of total medical revenue.

Formulas for calculating investment return
There are many formulas for calculating returns, but the three most commonly used are net present value (NPV), return on investment (ROI), and payback.

NPV is the difference between the amount of the up-front investment required to start a business venture and the discounted value of the future cash flows. The NPV will vary depending on the discount percentage used, and different practices will use different percentages.

ROI measures the efficiency of an investment. It is a ratio whose numerator is “Gain from Investment minus Cost of Investment” and whose denominator is “Cost of Investment.” It does not take into account the time value of money.

Payback is the length of time that it takes for a project to recoup its initial cost out of the cash receipts that it generates. The premise of the payback method is that the more quickly the cost of an investment can be recovered, the more desirable is the investment. Like ROI, it does not take into account any discount rate.

Many financial analysts argue that NPV is the most sophisticated measure of the three described above. However, investors’ access to capital is limited; therefore it is likely that they will be obligated to choose between alternative investments vehicles even if all of them have positive discounted cash flows. Investors in any business need to discuss alternative formulas for calculating investment return and come to closure regarding which formula they will utilize.

Lease vs. buy analyses
If an orthopaedic practice plans to pursue many of the income generation strategies outlined in the Primer, it will be necessary to acquire equipment. The question arises as to whether leasing or buying is the better option. The decision is not always an easy one to make because the two acquisition options both have advantages and disadvantages.

For example, leasing generally requires minimal down payment (or none); it may protect the practice against obsolescence; and payment may be spread over a longer period of time. Purchasing may provide tax advantages and the monthly costs may be lower, but it may restrict the practice’s financial operations. Making the correct lease vs. buy decision may be key to a business venture’s long-term success. Once a decision has been made in this regard, investors need to review the terms of the lease or purchase in detail to be sure they understand the financial and operational consequences.

Don’t rob Peter to pay…Peter
When a group of potential investors assesses the profitability of a business venture, they must consider what the impact of that venture may be on existing operations. For example, if a practice wants to open another office, it will be necessary to develop a pro forma that sets forth anticipated revenue and costs. It is likely, however, that some patients who otherwise would have gone to the first office will no longer do so, and this possibility must be taken into account. By the same token, it may also be the case that economies of scale may limit certain expense increases.

Seek counsel appropriately
Not infrequently, potential investors in a business are loath to seek counsel from outside experts because this can increase the initial cost of the investment. They may simply do some reading on a subject such as Stark, HIPAA, or anti-kickback or ask for information from a source who will give them feedback at no charge. This is never a good idea.

Anyone who desires to grow his or her current business, or create a new one, must consult appropriate advisors—recognizing that not all advisors can provide all kinds of advice. For example, an accountant may be able to assist with calculating profits and losses of an existing business but may not wish to be involved in projecting a future investment return. An attorney may know all about the law but may or may not feel equipped to weigh in on whether the business model makes sense. Investors must decide which advisors they need as part of their initial plan.

For more tips, visit the AAOS online Practice Management Center at www.aaos.org/pracman