Business Basics for Radiologists: Net Present Value

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Frank LexaAt the 2012 Annual Meeting & Leadership Summit of the California Radiological Society in San Francisco, Frank Lexa, MD, MBA, presented “Core Financial Principles for Radiology Professionals” on September 8. According to Lexa, who is vice chair and professor of radiology at Drexel University College of Medicine, using certain financial tools (such as modeling) is among, he says, “the core things you have to do, as a leader, to decide whether something makes financial sense.” He notes that many radiologists in practice make excuses for not understanding finance—and that these excuses are not valid. “People who can manage their financial systems well tend to be better radiologists,” he says. “You really do have to have expertise—and you, as radiologists, have a tremendous amount of insight that people outside our area don’t have.” In order to perform effective financial modeling, Lexa recommends the net present value (NPV) method, which “can be used to calculate just about anything,” he observes. For his educational demonstration, he offers the scenario of a partner in a moderate-sized practice that a national chain wants to acquire. “How do you analyze this, as the group leader?” he asks. “How do you know what they are really paying?” NPV and Payment Structure Lexa gives the example of a lottery winner who is offered the choice between a single lump sum or payments meted out over a period of 20 years. This, he says, is analogous to the payment structures that some groups are being offered as part of an acquisition, in which the choice is between a big initial payment (with cash, stock, and options) or smaller payments over time. “How do you compare these, over time?” he asks. The first distinction that must be drawn is that between revenue and cash. Revenue, Lexa explains, is a more abstract term for the monies to be received from a sale, while cash is the physical payment in the recipient’s possession. “This is an accounting distinction that allows for business realities,” he says. “Many financial problems and scandals revolve around this distinction, either on the asset or the debit side of the equation.” Lexa observes that whether revenue will actually turn into cash is always an uncertain proposition. “In almost every situation, you’d rather have cash than revenue,” he says. Key to this understanding is the concept of the time value of money, which accounts for the fact that as long as inflation progresses, any sum of money has more value today than it will have at any point in the future. “When you don’t get the full price you charged for an MRI, for instance,” Lexa says, “you lose twice: the difference between revenue billed and cash received, and the cost of the time value of the money.” Thus, Lexa concludes, in almost all situations, groups that are being acquired will find that they profit more from taking money up front than from accepting a payment structure that apportions the revenue over a long period of time. “Always take the money earlier,” he summarizes. NPV and Other Scenarios Evaluating a potential acquisition is only one of many scenarios to which the concepts of time value of money and NPV can be applied, Lexa says. With NPV, financial modeling can be performed for almost any scenario by mapping the sum of a practice’s outflows and commitments, balanced against its positive inflows, over time. Lexa stresses that all anticipated future cash flows must be corrected to reflect today’s value, otherwise known as present value, because money is never as valuable at any future point as it is today. Lexa observes that there is another commonly used budgeting measure known as internal rate of return (IRR), but he cautions practices against using it. “IRR can only be applied to very simple investments,” he says. “It is difficult to use in comparing projects of different sizes. Deep down, we need to be focused on comparing investments.” NPV, on the other hand, “works well, is easy to use, and can be used to compare investments of different sizes and magnitudes,” he says. By discounting future cash flow, the NPV approach accounts for inflation and the time value of money—two factors not included in the IRR model. With this model in hand, practice stakeholders can apply common financial measurements such as breakeven analysis. “In the simplest investment, the breakeven point is the point at which the sum of the revenue expected, adjusted for time value, exceeds what you paid,” Lexa says. “Something that pays me back in a year makes me interested. When you get out to a certain number of years, it becomes a tougher sell. Always remember that there is the null choice, which is the money you would keep by taking no risk.” The NPV of a potential investment is positive, Lexa says, if (given current inflation rates) the practice stands to earn at least $1.05 on every dollar invested. Otherwise, the investment will be less profitable than simply leaving the money in the bank to accumulate interest. “Always take projects with a positive NPV because you’ll come out ahead,” Lexa says. “If you are capital constrained, take the project with the best NPV.” Lexa concludes by reemphasizing the importance of understanding these basic financial concepts. “Finance is a core function of any system that runs on cash,” he says. “You have to understand how the dollars go through to make better decisions about everything.” Cat Vasko is editor of ImagingBiz.com and associate editor of Radiology Business Journal.