Mergers and acquisitions (M&A) in the healthcare sector are intricate and require meticulous financial due diligence for a successful outcome. One of the most crucial aspects of due diligence is understanding the quality of earnings (QoE) - an analysis that reveals the true economic health of the organization. Thorough due diligence helps identify potential risks and uncover opportunities, ensuring the deal delivers value for both parties. In this blog, we will delve into the key areas of financial due diligence, with a special focus on QoE analysis and how these elements can influence the outcome of a healthcare merger. 

Quality of Earnings and Financial Due Diligence 

Financial due diligence in healthcare mergers goes beyond simply reviewing the numbers—it’s about understanding the true economic picture of the organization involved. Quality of earnings (QoE) analysis is a fundamental aspect of due diligence that focuses on the sustainability and reliability of the revenue and profits of the healthcare provider. This process ensures that investors and acquirers have a clear picture of the financial landscape and can make informed decisions. By evaluating key financial areas, acquirers can assess the organization’s long-term viability and uncover risks that could impact the merger’s success.

Key Areas to Focus on in Financial Due Diligence 

1. Revenue Analysis

Procedure Mix

Understanding the mix of services provided is critical in assessing revenue predictability. For example, elective surgeries typically have higher reimbursement rates and better long-term growth potential than low-reimbursement, non-essential services like emergency room visits. Analyzing the procedure mix helps forecast future revenue and determine whether the organization's revenue is driven by predictable or volatile services.

Payor Mix

Analyzing the distribution of revenue sources (private insurance, Medicare, Medicaid, and self-pay) helps identify risks and opportunities. For example, a healthcare provider with a large percentage of Medicaid patients may face more reimbursement variability compared to a provider with a predominantly private insurance payer mix. This information helps forecast future revenue trends and understand the potential impact of changes in payer contracts.

Reimbursement Rate Trends

Examining historical reimbursement rates and understanding payer contract terms can reveal key insights into the sustainability of future revenue streams. For example, a healthcare provider may have relied on an outdated insurance contract, and due diligence might uncover that renegotiating the terms could lead to higher reimbursements.

2. Non-Recurring Revenue & Expense Identification

Distinguishing between recurring and non-recurring revenues or expenses is necessary in evaluating the sustainability of earnings. For example, a healthcare provider may report a one-time government grant as revenue, which could inflate their reported profits. Similarly, unusual or one-time expenses, like legal settlements or equipment write-offs, can distort the financial picture. Removing these non-recurring items ensures the acquirer can assess the organization's true, sustainable earning potential.

3. Personal/Owner Expenses

Many healthcare practices include owner-specific expenses that do not reflect the true operating costs of the business. Examples might include personal car leases or personal insurance premiums that are paid through the business. Identifying and eliminating these expenses during due diligence ensures that the financials reflect the true operating costs, giving the acquirer a clearer picture of the practice's financial health.

4. Accrual vs. Cash Basis Financials

Many smaller healthcare practices may operate on a cash basis for revenue recognition, which can create discrepancies compared to accrual-based financials. Additionally, some organizations may expense inventory right away rather than capitalizing it, which can also affect the financials. Understanding these differences ensures the financial picture accurately reflects the healthcare provider’s operational reality and avoids any misalignment during the merger process.

5. Working Capital Requirements

Healthcare organizations often have specific working capital needs due to payer reimbursement cycles, inventory management, and other operational factors. For example, a healthcare provider with longer reimbursement cycles from Medicare may face liquidity challenges that could impact cash flow during the merger process. Understanding these working capital requirements ensures that the acquirer is prepared for any post-merger integration challenges.

6. Cost Structure Analysis

Reviewing the healthcare provider's cost structure—including both fixed and variable costs—identifies potential cost-saving opportunities or inefficiencies that could impact long-term profitability. For example, if a provider has a high proportion of fixed costs relative to variable costs, they might struggle to adjust their financial model post-merger if the volume of patients decreases.

7. Debt and Liability Assessment

A thorough assessment of outstanding debts and liabilities, such as long-term loans, regulatory fines, or pending litigation, is necessary to anticipate financial obligations that could affect the merger’s success. For instance, if a healthcare provider has a pending malpractice lawsuit that could result in significant financial settlements, it could heavily impact the post-merger financial health of the combined organization.

Regulatory Compliance

Regulatory compliance requires focused attention in healthcare mergers due to the industry’s strict oversight. During due diligence, review billing practices to ensure alignment with industry standards. Improper billing can lead to penalties or the loss of reimbursement, which may significantly impact the merged organization’s cash flow. For example, an audit might reveal that a healthcare provider has been misclassifying services or charging for services not covered by Medicare, which could lead to significant financial penalties. 

Accurate documentation helps to avoid legal issues and ensure proper reimbursement. Reviewing and aligning documentation practices across organizations during due diligence helps prevent mistakes while ensuring compliance with licensing requirements and regulations like Medicare and Medicaid. For example, failing to verify that a provider is properly licensed in all operating states could result in regulatory fines or the inability to bill for certain services.

Integration Planning

Integration planning is crucial to the success of any healthcare merger. It ensures a seamless transition and helps mitigate risks associated with merging two complex organizations. Financial systems must be compatible, and reporting standardization is vital for aligning accounting software, revenue tracking, and reporting structures across both organizations. For example, during integration, discrepancies in financial reporting formats between two merging practices might make it difficult to consolidate data accurately, leading to delays or errors in post-merger financial reports.

Aligning internal controls is also essential for maintaining governance and preventing fraud. For instance, if one organization has robust internal controls but the other does not, it could result in operational inefficiencies or financial misstatements post-merger. Harmonizing accounting policies—such as revenue recognition, asset valuation, and expense reporting—is necessary to ensure consistency and prevent future complications. For example, discrepancies in revenue recognition practices could distort the true financial performance of the combined entity.

Partner with Lutz's Experts

Successfully navigating healthcare mergers requires experienced guidance and industry knowledge. At Lutz, our healthcare team and M&A team have helped numerous organizations complete successful transactions through thorough financial due diligence. We understand the unique challenges and opportunities in today's healthcare environment and can help design approaches that align with your organizational objectives. Contact us with any questions.