Monitoring Performance

Track Key Measures to Determine Business Trends and Gauge Growth and Profitability
By Dexter W. Braff

Not too long ago, business owners had to rely on a combination of manual ledger reports and gut instinct to manage their enterprises. Today, armed with a computer and basic off-the-shelf software, managers can quickly find data to unravel the mysteries of even the most complex business. But therein lies the problem. Too much information can be just as bad as too little. No manager has the time or patience to wade through the reams of paper computers heartlessly spit out to find the one necessary piece of information.

The following article reviews an example of a monthly management report. It is designed to survey the broad landscape of a business and subsequently focus management's attention on the most critical issues affecting success - revenue, expenses and cash collections. Although further analysis might be required to determine the root cause of a problem, this report can alert management that a problem indeed exists and identify where the investigation should begin.

Revenue Analysis
For the typical home medical equipment (HME) company, analyzing revenue presents unique challenges. The bulk of its revenue typically comes from an existing rental base, thus trends in new rentals often go unnoticed, even thought they are the lifeblood of the firm and are the best predictors of future performance. Accordingly, this management report highlights new rentals in total, as well as new rentals in product areas key to management's strategic objectives.

For example, many firms today are focused on increasing respiratory revenue-specifically oxygen-to improve overall profitability. By analyzing both new oxygen patients and total new rentals, management can better predict both future revenue and make shifts in product mix.

With managed care playing an ever-increasing role in the industry, providers cannot afford to assume that all growth is good. As a firm's mix shifts to more discounted business, revenue might indeed grow, but at reduced margins. This can severely erode profitability, so the impact of discounted pricing must be monitored carefully.

This report includes two pivotal performance indicators. The most obvious is gross profit margin. Most firms do not, but should, calculate gross profit after rental equipment depreciation, equipment leasing expenses or other direct rental equipment cost such as maintenance, because these costs are directly related to the revenue generated by the products.

If margins are declining, it can't necessarily be assumed that discounted pricing is the culprit. Reductions in gross profit can also occur due to a shift in product mix. For example, as a firm increased its sales business compared with rentals, it can usually anticipate a drop in gross profit without any pricing reductions.

To supplement the gross profit measure, the report includes a second, more subtle indicator of managed care's impact. For the firm's key product areas, average revenue per patient is measured as a percent of Medicare allowables. By computing average revenue and comparing the numbers to the Medicare standard, firms can quickly gauge the effect discounted pricing had on strategically important product areas.

For example, if the Medicare allowable for oxygen is $275 and the average revenue per oxygen patient, over six months, declines steadily from $275 to $192.50, or 70 percent of Medicare, it is clear that an increasing number of oxygen patients are being billed at discounted rates. Although the measure alone cannot isolate how much business is coming from managed care and at what discounts, it does capture its aggregate impact. Furthermore, it drives home the point that although overall revenue might be climbing, margins are shrinking. Left unchecked, this can compromise long term-profitability.

Expense Analysis
Business owners clearly need to monitor expenses carefully to insure profitability. However, they need to be careful to ensure meaningful analytical results. For the management report, operating expenses should be adjusted to include the owner's entire compensation including perks, as well as extraordinary one-time expenses such as accreditation costs. These expenses might not reflect the true day-to-day costs of doing business and can fluctuate drastically, thereby distorting monthly trends.

In the report, adjusted operating expenses are presented both in raw form and as a percent of revenue, and then trended over time. This enables management to monitor total expenses while factoring out changes that can occur as a result of changes in revenue. For example, a 10 percent increase in quarterly expenses from $500,000 to $550,000 might appear unfavorable by itself. However, if revenue over the period also increased 20 percent from $1 million to $1.2 million, expenses as a percent of revenue actually fell from 50 percent to 46 percent. Both pieces of information are necessary to monitor the firm's cost structure.

Because the largest expense area is typically personnel, the management report also calculates annual revenue per employee. Changes in these productivity measures can provide advanced notice regarding changes in staffing requirements.

Cash Collections Analysis
Cash collections continue to be one of the most difficult tasks facing managers. Any change in billing or payment procedure by any payer-Medicare or otherwise-can have a dramatic and immediate impact on cash flow. Thus management must pay particular attention to these performance measures, both to predict cash flow and develop strategic initiatives to improve results.

This management report includes several measures of cash collection performance. The most popular measure is days sales outstanding (DSO), which conceptually shows the number of days it takes to collect billed revenue. However, this number can sometimes be misleading. For example, a company with a high DSO might, in fact, be collecting cash extremely well. This can occur when the firm has a substantial amount of excessively old accounts receivable on the books. Although it could be collecting current billings on a timely basis, the calculation will nevertheless significantly overstate this number.

Similarly, a low DSO figure is not necessarily good. Accounts receivable can be reduced in two ways - by collecting cash and writing off accounts as bad debt. Both lower DSO, but only one generates cash. In light of the above, this analysis is supplemented with a measure of current cash collections as a percent of prior billings. Not only can this measure clarify DSO, but it can serve as the basis for developing an allowance for doubtful accounts (an accounting procedure used to project bad debt on current billings), as well as a cash flow forecast.

The collections analysis concludes with a measure of pending DSO. This measure can be extremely valuable for companies that track unbilled revenue - billings that cannot be released until additional data is obtained - because delayed billing can add substantially to the collections cycle.

Profitability Analysis
Finally, several measures of profitability are included to show the impact of changes in the critical factors discussed above. More often than not, changes in profitability mirror changes in one or more of these performance areas.

Accrual-Based Accounting
To conduct a meaningful business analysis, financial statements must be prepared on an accrual basis, even though cash-basis accounting, which recognizes revenue when collected and expenses when paid, appeals to many owners whose primary concern is cash flow.

Unfortunately, cash-basis statements are virtually useless in providing other managements insights because they can substantially distort day-to-day operating results. This was never more evident than during the conversion to the Durable Medical Equipment Regional Carriers in the first six months of 1994.

During this transition, cash-basis home care owners were lamenting their "reduction in revenue and profits", when in fact, assuming normal collectability, nothing fundamentally changed in their businesses. Accrual-based statements, which generally recognize revenue when billed and expenses when incurred, do not reflect this volatility in cash flow. By "matching" revenue and expenses, these statements provide substantially greater insight regarding the "normalized" performance of the firm.

This is not to suggest that changes in cash flow patterns are unimportant. Rather, they can be measured in other ways without resorting to cash-basis statements and thereby compromising the integrity of management information. Examples are measuring DSO or actual cash collections as a percentage of revenue (see sample report in our software program, Monitoring Performance Measures).

Data Collection
Most of the information used in this report can be extracted from billing software management reports and monthly financial statements. Check with software vendors and accounting professionals. If the information is not readily available, rather than abandoning the performance measure, consider improvising. For example, if new rental revenue cannot be identified, consider tracking rental deliveries. Or, if financial statements are prepared on a quarterly basis and monthly expenses are unavailable, consider tracking payroll expenses, purchases or other big-ticket items that might significantly affect performance.

Remember that the report is a tool to help managers get a handle on the myriad of issues affecting the business. Even if source material is limited, companies are better off tracking what they have, rather than ignoring it altogether.

Although employees can gather the appropriate information, input the data and deliver a final report for management review, managers should consider preparing these reports themselves. The simply act of routinely meeting with appropriate personnel to secure necessary information and physically inputting the data gives managers a more intimate feel for the business and how it is performing. The process can also facilitate communication with key employees and discipline managers to stay close to factors that contribute to the firm's success. This in turn can reveal subtler but equally important issues not captured by the numbers alone.

Data Interpretation
Once the information is assembled and the report prepared, how should the results be interpreted? Although it is tempting to compare the results to industry benchmarks, such comparisons should be done with caution. Every business has its own unique characteristics and reports information differently, which can make such comparisons somewhat invalid.

Moreover, simply knowing the company compares favorably or unfavorably to an industry benchmark can provide entirely misleading results. For example, although a firm's profitability might be above the industry standard, should a manager be pleased if the management report reveals that profitability has been declining steadily during the past 12 months?

Management reports allow for quarterly and monthly trend analysis. Subtle changes in performance over time can direct management to potential problem areas early, before they seriously compromise the firm. Moreover, trend analysis focuses management on continual internal improvement, which is its primary concern regardless of external benchmarks.