Volume 9, Issue 16, August 2, 2022

During the healthcare M+A process, the benefit of accurate financials cannot be understated. Financial reporting is the foundation on which your business is valued, and meaningful data presented in an organized fashion can lower a buyer's perceived risk. This likely means more money in your pocket on the closing date.

Yet, it is an all-too-common occurrence to see frustrations arise as a healthcare business owner works through the financial due diligence process. The lists are exhaustive, the requests elaborate, and the stakes high. By taking a few steps, even 3-6 months before you go to market, the due diligence process can be simplified in an impactful way. Sailing through financial requests allows an owner's focus to be rededicated to other, equally important parts of the sale process.

Here are five steps to consider taking to better prepare your financials in anticipation of an exit.

1. Switch to Accrual Method Accounting

The accounting method affects the timing of when revenue and expenses are recognized and can have a material effect on your profit and loss statement (P&L) from one period to the next. In accrual accounting, revenue is recognized when earned, and expenses are recognized when incurred, regardless of cash inflow or outflow. On the other hand, cash accounting recognizes revenue and expense as cash flows into or out of the business.

Let's look at a few examples that help show how cash and accrual method accounting differ.

Revenue example — A client entered a 30-day rehabilitation program on Dec. 1, 2021. The client uses insurance to pay for services, and the provider is reimbursed $10,000 for services on Jan. 15, 2022.

Accrual method: Revenue of $10,000 is recognized in December 2021 because that is when services were rendered.

Cash method: Revenue of $10,000 is recognized in January 2022 because that is when the payment was received.

Expense example — A provider receives an invoice for $15,000 from a medical billing vendor on Jan. 5, 2022, for services provided in December 2021. The provider pays the invoice on Feb. 1, 2022.

Accrual method: An expense of $15,000 is recognized in December 2021 because that is when the expense was incurred.

Cash method: An expense of $15,000 is recognized in February 2022 because that is when the invoice was paid.

While each method has pros and cons, the primary benefit of the accrual method is the matching of revenues with the expenses incurred to produce those revenues. This cause-and-effect relationship of revenues with expenses is called the "matching principle" and is a part of generally accepted accounting principles (GAAP).

The accrual method of accounting is usually preferred by investors as it paints a clearer picture of operating profitability. Although many business owners use the cash method of accounting due to its overall simplicity, this approach can result in unexpected and unfavorable adjustments to EBITDA and have an impact on working capital. Making the switch to the accrual method requires knowledge of advanced accounting concepts and may feel daunting. An experienced bookkeeper or certified public accountant (CPA) can make this transition with ease, and getting it done right is worth the additional expense.

2. Clean Up Your Chart of Accounts

Your P&L tells the story of your profitability and financial health by providing a summary of your revenues and expenses over a period. Just as it helps a business owner make informed decisions, buyers rely on this financial statement to make informed investment decisions. To be an effective decision-making tool, your P&L needs to be organized in a way that is easy to comprehend. A well-assembled P&L starts with the chart of accounts (COA).

The COA is a listing of all general ledger accounts and allocates each account into five primary groups: assets, liabilities, equity, revenue, and expenses. Accounts can be further grouped into classes, divisions, or departments, if desired. A little extra time spent when determining which accounts to use can save headaches down the road and add tremendous value to your financial reports.

Here are a few things to consider when organizing your COA:

• Make your COA work for you. It should mirror how you want to see the business and prioritize operational functionality over GAAP or tax reporting. Those adjustments can always be made later.
• Include enough account detail to allow the user — the individual(s) who reviews your financials — insight into how the company operates. For example, each stream of revenue should have its own account, but accounts at the customer level are likely not necessary.
• Limit the number of accounts used to avoid overwhelming the user and causing them to miss big-picture trends. Limit the number of accounts in total or only create a new revenue or expense account if it represents a specified threshold of revenue. New accounts should only be added if they add value.
• If sub-accounts are created under an expense, do not record journal entries under the main account. This can appear careless to the user of the financials.
• Use accounts labeled "other" or "miscellaneous" sparingly as these labels create uncertainty in the eyes of the user.
• Thoroughly consider the assignment of each expense as either a cost of revenue or an operating expense. Classification impacts your gross margin, a metric that buyers will benchmark against their operations and other potential investments.
• Ensure consistent use of accounts over time. This is especially important if you switch bookkeepers. If 1099 contractors are recorded in "consulting expense" one year and "professional fees" the next, you lose the ability to monitor trends occurring over multiple periods.
• Avoid account redundancy. Account redundancy occurs when you have the same account in more than one place in the P&L. An example would be having an account for office supplies under administrative expenses and another office supplies account under office expenses. This is confusing to the user. If this occurs, most accounting software platforms have a "merge account" feature to join the two accounts while retaining historical accuracy.

Any changes made to clean up your COA should be deliberate and executed carefully. Consider how changes made will affect the comparability of financial data across years. The beginning of a fiscal year is the best time to make these changes. A seasoned accounting professional can be especially helpful in this process.

3. Analyze Your Income Statement

The P&L is only useful to the extent that it is analyzed. If you are only looking at the bottom-line number each period, you are missing valuable insight that could assist you in making quick decisions that drive value and profitability. Regular analysis of your financials is a habit that pays dividends and will position you ahead of the game when fielding questions from buyers.

These routine practices will allow you to speak confidently about your company's financial performance:

• Budget to actual review: It is a worthwhile practice to compare your actual results to the budget at the end of each reporting period. Analysis should be completed for the current period and year-to-date. Variances are calculated in dollars and percentages, and thresholds can be determined for prompting further review. Documenting this review and explaining why variances occur will prove to be a great resource during financial due diligence.
• Key performance indicator (KPI) trend analysis: KPIs are quantifiable measures that index a company's performance over time. They are the indicators of a company's self-defined measures of success and vary based on objectives specific to each organization. Common KPIs in healthcare include average daily rate, average daily census, average length of stay, and EBITDA margin. KPIs are often reported visually using charts, graphs, and trendlines to show trends in these metrics over time.
• Common size income statement: This helpful presentation of the P&L shows each line item presented as a percentage of revenue and shows how each revenue and expense line item affects profitability. The common size P&L makes the financials easy to compare across multiple periods or against other companies. Items to keep your eye on in this analysis include the cost of sales, gross margin, payroll, and other material expenses.
• Monthly P&Ls: Although seemingly simple, preparing monthly P&Ls lined up side by side in one spreadsheet for a period of 3-5 years in advance of going to market can save precious time and resources during due diligence.

4. Solidify Your Month-End Close Process

An accounting close process performed consistently results in meaningful and accurate financial statements on a timely basis. A routine and thorough close process for each month and year-end will provide a quick-to-access library of financial information you may be required to provide during the sale process. A well-designed close process yields the three must-have financial statements — balance sheet, P&L, and statement of cash flows — which allow users to thoroughly evaluate a company's financial soundness and a potential buyer to assess value.

A solid close process includes the following elements:

• Knowledgeable and accurate accounting team: The outputs of the accounting software are only as accurate as the corresponding inputs (i.e., garbage in = garbage out).
• Hard close process: Once all data entry and journal entries are complete for a given period, the period should be "locked down" in the accounting software. This hard close restricts software users from making retroactive changes. Typically, this lockdown requires password protection, and only the administrator (admin user) can unlock a period in rare circumstances. This prevents changes to the financials after the issuing of reports.
• Close folder: Create a folder for each period that houses all documents pertinent to the period, such as bank statements/reconciliations, loan statements, sub-ledger reconciliations, documentation supporting revenue, and balance sheet reconciliations. Final copies of the financial statements and any additional analysis should also be stored here.
• Formal executive review: Provide financials and corresponding analysis to the business owner at the end of each close process along with a narrative detailing the periodic results, making note of important or unusual items. There should be evidence of a completed owner/executive review via email or manual signoff.
• CPA review: If there is no CPA on staff, a licensed CPA should complete a quarterly, or at the very least annual, review of financial statements. An accounting professional can bring accounting issues to light and be a useful tool in preventing fraud. This review will also give buyers increased confidence in the reliability of the financial statements provided.

5. Locate and Organize Important Financial Documents

Creating a file that houses important financial documents in advance of going to market can be an easy way to save time and prevent unnecessary stress. The ability to easily locate important documents could prevent delays in the sale process and gives the impression of an organized, well-managed organization.

Documents to consider for this file include the following:

• Business formation documents
• Partnership/LLC/operating agreements
• Tax filings
• COVID-19 loan forgiveness documents
• Audited financials, if applicable
• Budgets and forecasts
• Insurance policies
• List of contingent liabilities
• Leases
• Customer/payor contracts
• Vendor contracts
• Policies and procedures documentation
• Lease agreements
• Documents pertaining to any ongoing litigation

Getting Started in the Right Direction

The goal of financial due diligence is to give a potential investor an understanding of ongoing profitability by examining historical performance, trends, forecasts, working capital needs, and other qualitative metrics. Allowing a third party to peek into the inner workings of your business can be burdensome, expensive, and overtaxing if you are not properly prepared. Completing the steps discussed above will start you on a path to an uncomplicated due diligence process while also helping you better manage your operations. It is a win-win.

If you are considering an exit and unsure how to get these processes in motion, please reach out to the healthcare M+A team at VERTESS.