Tracking practice performance over time using established financial metrics is an essential element of hearing healthcare practice management. It can elucidate trends in financial resource use and provide managers with information on which to base decisions.
This article describes six common metrics used to evaluate the financial status of an organization. The main focus will be on liquidity and profitability.
LIQUIDITY RATIOS: KEEPING CURRENT
Liquidity is the ability to turn assets into cash. As such, liquidity ratios provide information about whether a practice can pay its short-term debt obligations.
The current ratio, which divides current assets by current liabilities, is one example of a liquidity ratio. It is used to assess an organization's capacity to meet its financial obligations within an upcoming time period, often 12 months.
For a hearing healthcare practice, examples of assets included in the current ratio are accounts receivable and inventory, as both have the potential to be turned into cash in a reasonable amount of time, unlike diagnostic and office equipment.
What's considered an acceptable current ratio will vary depending on the specific circumstances of a hearing healthcare practice. For example, one that was recently established is likely to have a lower current ratio than an established practice due to the purchase and financing of start-up equipment and initial marketing activities.
Say a practice has $200,000 in current assets and $400,000 in current liabilities, for a current ratio of.5. In other words, the practice has half the assets needed to cover its short-term financial obligations. This example may represent a newly established hearing healthcare practice.
A current ratio between one and three is often considered desirable by lending institutions because it suggests the practice can meet its financial obligations.
However, the current ratio has the potential to be somewhat misleading, as it assumes the use of all current assets to pay current liabilities. A hearing healthcare practice should not rely on using all assets to cover its liabilities.
The quick ratio, also known as the acid-test ratio, can provide a more accurate picture.
THE ACID TEST
The quick ratio is a measure of a practice's ability to meet short-term obligations using assets that can readily be converted to cash—short-term investments, accounts receivable, and cash.
It excludes inventory assets, as these may not be converted to cash quickly enough to provide the funds required to meet current financial obligations.
For a hearing healthcare practice, excluding inventory—most often in the form of hearing aid inventory—should provide a better estimate. When there are notable reductions in customers to purchase hearing aids, the ability to meet short-term obligations may be compromised.
A quick ratio between one and two is considered desirable by many lenders and accounting professionals.
Even though the quick ratio is a more conservative liquidity estimate than the current ratio, including accounts receivable in the calculation has the potential to overestimate the amount of available cash, as there is no guarantee that the assets in accounts receivable will be collected within a reasonable amount of time, or at all, to meet current obligations.
SHOW THE MONEY
That's where the cash ratio comes into play. While this ratio is similar to the current and quick ratios, it is an even more conservative estimate of liquidity.
This ratio does not consider accounts receivable or inventory. As the name implies, the cash ratio includes cash, cash equivalents, and investments.
It is common for this ratio to be less than one because companies typically do not maintain levels of cash that would cover all current liabilities, as that is not considered good asset utilization.
COMING TO COLLECT
The average collection period provides information about a practice's capacity to convert accounts receivable into cash. This concept is very similar to the days in accounts receivable metric.
The average collection period is calculated using a two-step process: 1) divide net sales by the number of days in the year, and 2) divide this figure (average daily sales) into accounts receivable.
While there isn't an industry benchmark for this metric, reducing the average collection period increases cash flow and improves the ability to meet short-term financial obligations.
NOTHING BUT NET PROFIT
Net profit on sales reflects a practice's ability to generate profit on sales. For hearing healthcare practices, this metric will most often represent profit on hearing aid sales.
The ratio is calculated by dividing net profit by net sales. What's considered an acceptable number will vary depending on practice goals and the profits required to meet financial obligations.
If a practice's net profit is $25,000 and net sales are $100,000, the net profit on sales is.25, or 25 percent. In other words, the practice profits $25 for every $100 in sales. The remaining $75 is used for paying expenses, such as practice overhead, cost of goods sold, and other variable expenses associated with the sale.
MAKING A RETURN
Often referred to as return on investment (ROI), return on assets (ROA) provides an indication of a practice's profitability relative to its total assets. Stated another way, it specifies how well practice assets are being used to generate profit. It is calculated by dividing net profit by total assets.
This ratio also can be used to determine the effectiveness of particular practice expenditures, such as marketing expenditures. In the latter case, the total expense associated with a given marketing project is divided into the resulting profit.
The information in this article is not intended to replace consultations with licensed accounting professionals but instead to provide the hearing healthcare manager with a better understanding of financial metrics used to gauge the financial “health” of a practice.
Careful, consistent evaluation of practice performance is critical to maximizing financial outcomes.
Readers are encouraged to build upon the introductory information presented here as they develop a thorough understanding of concepts and processes involved in financial analyses.