“My practice is doing great! We are growing 15%!” A dermatologist with a growing clientele told me happily. She was contemplating a sale in a few years.
The physician was not wrong. Revenue exceeded $10 Million and was growing. Profit margin was 20 percent. She had a tenured team and a loyal client base. Her business had over 500 Google ratings averaging 4.8.
But that was not the full story. When I dug into the practice’s financials, I found their collections rate (the percentage of their charges they collected payment on) was 88%. Their average days receivable (the time it takes to collect payment) was almost 80 days.
In other words: Every year, the practice failed to collect payment on approximately $1 million of annual billings. And if they invoiced a patient in July, on average, they would not get paid until October.
Most businesses focus on growing top line, and justifiably so. From prospecting to invoicing, the process of making money is complex and hard. However, when we neglect downstream activities such as collections, the business suffers.
A Tale of Two Medical Practices
Consider two independent medical practices. Both report $10 million of annual patient charges and identical EBITDA. On the surface, they appear to be equally profitable. Yet an informed buyer would likely pay more for Practice A than for Practice B.
Practice A |
Practice B |
|
| Annual Patient Charges | $10.0M | $10.0M |
| EBITDA | $1.8M | $1.8M |
| Collection Rate | 97% | 88% |
| Collections | $9.7M | $8.8M |
| Days Accounts Receivable | 32 | 78 |
| Bad Debt Experience | Low | High |
Practice A consistently converts billings into cash with minimal delay. Practice B experiences slower collections, older receivables, and higher write-offs. Although the historical income statements appear identical, the underlying economics are not. Payer mix, contractual adjustments, billing effectiveness, denied claims, write-offs, and collection speed all influence the amount and timing of cash receipts.
Why This Matters in Valuation
A buyer acquiring Practice B must either wait longer to receive cash or invest additional working capital to finance operations while receivables remain outstanding. Both outcomes reduce the economic attractiveness of the investment. Consequently, weaker collection performance may translate into lower expected cash flow, higher working capital requirements, or greater perceived risk, all of which can reduce business value.
Business valuation is based on expected future economic benefit, not simply historical accounting results. A valuator asks whether the financial statements are representative of the business’s future earning capacity. If changes in billing processes, payer mix, or collection performance suggest that future cash flows will differ from historical results, normalization or working capital adjustments may be appropriate. Because business value is driven by expected future cash flow, these adjustments can materially affect the valuation conclusion.
The Broader Point
The same principle extends well beyond healthcare. Manufacturers, distributors, contractors, and professional service firms all have operational characteristics that may not be fully reflected in the income statement. Valuation requires understanding how a business generates cash, not simply how it reports revenue and expenses.
Conclusion
Revenue is an important measure of business activity, but it is not synonymous with economic value. Business valuation seeks to determine the future economic benefits an owner can reasonably expect to receive, requiring an understanding of the operational and financial factors that drive sustainable cash flow. Consequently, valuation extends beyond the income statement to evaluate the underlying economics of the business.
Sri Chakravarty, CVA, is the founder of ProfitAbility. He provides independent business valuations, business plans, and transaction-related financial analysis for closely held businesses. His work supports acquisitions, ownership transitions, financing transactions, and other situations where a defensible understanding of value is critical. Learn more at www.profitability-solutions.com.
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