Managing Efficiencies in Pharmacy Cash Flow

Objectives

1. To explain the importance of cash flow to business operations.
2. To list three types of business activities that can influence cash flow as represented by a cash-flow statement.
3. To identify the sources and uses of cash flow in a community pharmacy.
4. To describe five strategies to improve cash flow in a community pharmacy.
5. To interpret liquidity, solvency, and efficiency financial ratios.

Financial Statements

Cash is vital to a business. Without cash, it is difficult to purchase new equipment, pay salaries, and buy inventory. Thus it is imperative for business owners, including pharmacy owners, to manage their cash flow.

For example, sales on the income statement may total $120,000 for the past month, indicating that the business is doing well. However, if 50 percent of the sales generated are paid by third-party payers, it is possible that the pharmacy has not received any cash from these sales at the end of the month. If the cash from these sales is not being received in a timely manner, it may be difficult for the pharmacy owner to pay his or her bills (e.g., salaries, rent). This is why many businesses appear to being doing well on paper, but then go out of business. Again, cash is the lifeline to operating a business.

Often business owners primarily use accrual base accounting and focus on the income statement (i.e., profit and loss statement) and the balance sheet. Accrual base accounting means sales are made and expenses are recorded when they are incurred (not when they are paid). Alternatively, cash based accounting means transactions are recorded only when cash changes hands. A cash-flow sheet is a financial statement that provides a summary of cash flow (i.e., how much cash is flowing in and out of the business during a given time period).

Because all three financial statements (income statement, balance sheet, and cash-flow statement) are important, pharmacy owners and managers must know how to interpret the information on all three statements. Understanding and using all three will facilitate business decision making.

Income statements summarize the flow activity and transactions over a specific period of time. Revenues from sales, cost of goods sold, and expenses relating to those revenues generated are included on the income statement, as shown in Table 1. Balance sheets describe the value of a company at a given time (see Table 1). They present the assets owned by the company (e.g., cash, accounts receivable), the liabilities owned to others (e.g., accounts payable, loans payable), and the owner's equity (e.g., common stock, retained earnings). Cash-flow statements tell you what cash has come in and what cash has gone out of a business within a specified time period. The remainder of this article will focus on cash-flow statements and how to efficiently manage cash flow.

Cash-Flow Statements

Cash flow statements are divided into three categories that represent three types of business activities that influence cash flow, as described below. An outline of a cash-flow statement is provided in Table 2.

• Net Cash Flow from Operating: This section details the cash generated from day-to-day operations and the cash spent on day-to-day. For example, paying the wholesaler invoice is a day-to-day operation activity that would decrease cash flow.
• Net Cash Flow from Investing: This section pertains to the cash generated and used by long-term investments. For example, selling a piece of land would increase cash flow but paying cash for a new computer system would decrease cash flow during this time period.
• Net Cash Flow from Financing: This section of the statement pertains to the exchange of cash due to financing. For example, when a store repays debt, the statement reflects cash flowing out of the business. In contrast, when a store takes out a loan from a bank, cash is flowing into the business during this time period.

Note that cash-flow statements do not include depreciation because it does not involve cash flow out of the business. Similarly, cash-flow statements do not include inventory, accounts receivable, or accounts payable. They only detail actual exchange of cash.

The pharmacy owner or manager can review these sections of the cash-flow statement to detect cash sources and needs. It provides management with a summary of where money is being spent and where money is being obtained. When a company is healthy, operating activities should generate cash. Using the cash-flow statement, management can tell whether operating are generating cash for the company or whether cash is being generated in other places (e.g., selling land or equipment, selling investments). To many financial analysts, cash-flow statements are the most important of the financial statements. The ability to manage cash needs is often the key to success for many pharmacies.

Managing Cash Flow Efficiently

To illustrate the importance of cash flow and to provide tips on managing cash flow more efficiently, several case examples will be used. Each case example illustrates a concept that can be used to improve cash flow.

It is important to remember that when making decisions, the short-term effect on cash-flow may be different from the long-term effect. For example, participating in a third-party program may hinder cash flow immediately since payment for those prescriptions will not be received for a couple of weeks. However, the long-term effect may be increased traffic into the store, resulting in increased sales.

Another illustration would be the decision to offer senior-citizen discounts. Again, this decreases the sale price and the gross margin, hindering immediate cash flow. In the long term, sales may increase due to this decision. When making business decisions, it is important to consider both the short-term and long-term effects on cash flow, sales generated, gross margin, and net profit.

Table 1: Review of Income Statements and Balance Sheets

Table 2: Cash-Flow Statement Outline

CASE EXAMPLE 1: ACCOUNTS PAYABLE

Pharmacy A: The pharmacy owner is very particular in keeping her accounts payable to a minimum. She decides to pay the remainder of her yearly rent this month ($4000). She also pays all bills (e.g., utilities, wholesaler invoice) upon receipt. Sometimes, this creates a bind at the end of the month when there is little cash in the bank to cover the salary checks.

Pharmacy B: The pharmacy owner pays the monthly rent on the fourth of every month. (It is due on the seventh.) She pays all other bills close to the due date. She always pays promptly; however, she realizes the importance of holding onto the cash as long as possible.

Discussion: These two pharmacies illustrate the importance of judicious monitoring of accounts payable. It is suggested that Pharmacy B has better cash-flow management. The owner of this pharmacy realizes that it is usually best to pay suppliers close to the due date. It is important to pay them in time to receive the cash discounts, but no sooner because paying early is like giving an interest-free loan.

Alternatively, the owner of Pharmacy A struggles with cash flow because of poor management decisions, not because of poor sales. Paying rent for the entire year (unless a discount is given) could hinder cash flow. This would be analogous to a homeowner making mortgage payments for the entire year in January before receiving a salary for the year. Having a cash-flow statement can provide information on when money comes into the business and when it is best to pay out money.

The objective then for paying bills or disbursing funds is to extend the time between receiving an invoice and issuing a check for payment. Early disbursement of funds can be as wasteful as incurring a late payment. For example, paying a $25,000 invoice in 15 days rather than taking the 60 days allowed, costs the pharmacy $183.93 assuming the funds could have been invested (9 percent interest rate). Several suggestions for managing and controlling the disbursement of funds are as follows.

• Centralize the payment of bills. Have one cash manager who is responsible for controlling disbursements and tracking their clearance.
• The cash manager should also negotiate with suppliers to receive extended credit time. A 60-day credit period is more beneficial than a 30-day period.
• Time payments so as to pay at the latest date possible to receive discounts. For example, if a wholesaler invoice states, "1/10 net 30," the pharmacy should pay the invoice within 10 days to receive the 1 percent discount. If the pharmacy owner does not pay within the 10 days, he is essentially paying 1 percent for the use of that money for the next 20 days or 18 percent per year for funds used during the additional days.

CASE EXAMPLE 2: INVENTORY

Pharmacy A: It is Friday, June 29. The pharmacy owner realizes that he is out of a high-cost item. His wholesaler bills him at the end of every month. If he orders the product today, he will have to pay for it by July 10. If he waits until Monday he won't have to pay for it until August 10. Considering his patient population and whether it is likely that this medication will be needed on Saturday he opts to wait and order it on Monday, July 2.

Pharmacy B: It is Friday, June 29. The pharmacy owner realizes that he is out of a high-cost item. His wholesaler bills him at the end of every month. If he orders the product today, he will have to pay for it by July 10. If he waits until Monday, he won't have to pay for it until August 10. The pharmacy owner decides to order it today. Better to have too much stock than not enough. He also asks the technician to glace over the shelves and order anything else that is low in stock.

Discussion: This case example exemplifies the importance of inventory control when attempting to optimize cash flow. Inventory control is one of the key factors to success in pharmacy ownership because it can tie up a lot of cash. In the example above, the owner in Pharmacy A realizes the importance of keeping the investment in inventory to a minimum. By waiting until Monday, he can keep the cash for another month. The other owner (Pharmacy B) ordered as needed without any respect to the cost of the medication and the timing. This pharmacy owner will have to pay for this inventory within the next two weeks, thereby increasing the amount of cash flowing out of the business. Pharmacy owners should strive to decrease the time between paying for the merchandise and selling it.

The cost of inventory is probably the largest expense that pharmacies have in doing business, and thus deserves more discussion. Having too much stock or not having enough stock is considered to be a primary cause of pharmacy failure. Therefore, the efficient management of inventory is an important aspect of pharmacy operations.

Inventory management is the practice of planning, directing, and controlling inventory so that it contributes to the business' profitability. In inventory control, the goals are to minimize the inventory investment while maintaining a balance between supply and demand. Carrying extra inventory or inventory that will not sell decreases cash-flow efficiencies. An inventory analysis sheet, as shown in Table 3, can be used to determine where a pharmacy may be overstocked or understocked on certain items. Many inventory systems or wholesalers can provide this type of analysis.

Evaluating the wholesaler and payment of the wholesaler is important improve cash-flow efficiencies. It is suggested that pharmacy owners periodically evaluate their wholesalers and suppliers to ensure that they are receiving competitive prices and discounts. Often wholesalers provide cash discounts for prompt payment of invoices. Paying at the latest date, yet on time, can keep overall expenses lower, increase the gross margin, and improve cash flow.

Other discounts, such as quantity discounts, must be reviewed on a case-by-case basis. For example, purchasing 50 pairs of crutches at a reduced price is only beneficial if all 50 will sell. If you have suspect that you will only be able to sell 10 pairs over the next year, then you are tying up money with no expected return. Table 4 provides an example of how discounts can be combined to reduce the cost of goods sold and improve the gross margin.

CASE EXAMPLE 3: ACCOUNTS RECEIVABLE

Pharmacy A: Monthly revenue for this community pharmacy averages $200,000. Approximately 70 percent of the prescriptions are paid for by third party. Approximately 10 percent of the cash customers have charge accounts. The business clerk for the pharmacy receives the third-party checks and deposits them. The charge accounts are reviewed yearly when tax returns are being prepared. Every once in awhile, it is difficult for the pharmacy to pay its wholesaler. Fortunately, the owner keeps some cash reserves in her checking account.

Pharmacy B: Monthly revenue for this community pharmacy averages $200,000. Approximately 70 percent of the prescriptions are paid for by third party. Approximately 10 percent of the cash customers have charge accounts. The business clerk for the pharmacy receives the third-party checks, then reconciles the statements. She realizes that three claims billed to a third-party payor were not paid, and she begins to investigate the reason. At the end of the month, she mails bills to all charge-account holders.

Discussion: Illustrated in this example is the importance of monitoring accounts receivable to efficiently manage cash flow. The owner of Pharmacy A is only concerned with sales generated. It is assumed that if a prescription is dispensed, it is paid for by either the third-party payor or the patient in a timely manner.

Prescriptions dispensed does not mean cash has been received from these sales. Moreover, this owner uses cash reserves for everyday operations. Associated with this is opportunity cost. The money in the checking account could be invested or put into savings to draw interest if it was not needed continuously to facilitate cash flow for the pharmacy. The owner of Pharmacy B has a system whereby staff personnel are reviewing accounts receivable to ensure that the pharmacy is being paid in a timely manner for the prescriptions dispensed.

A study funded by the NCPA Foundation demonstrated that pharmacists are losing money by not reconciling their third-party insurance claims. A net loss of money occurs to the pharmacy due to discrepancies between the amount billed to the insurance company versus the amount of claims paid by the company. It is imperative that pharmacy owners review their accounts receivable periodically to ensure that the cash is flowing into the business.

Third party contracts should be evaluated, specifically on their reimbursement rate and their reimbursement schedule (e.g., weekly or monthly). Likewise, to manage accounts receivable and minimize bad debt, it is suggested that management screen credit applicants. A balance is necessary in screening applicants for credit. Being too harsh and strict may result in decreased sales, and being too lenient may result in a large accounts-receivable account that creditors cannot pay. Other guidelines for managing accounts receivable include the following.

• Allow charges for prescription items only.
• Have one person responsible for ensuring that accounts receivables are collected. This may seem like an additional expense, but collecting accounts receivables contributes to the pharmacy's overall profits.
• Mail bills promptly and regularly to charge account holders.
• Start calling account holders as soon as the bill is overdue. Consider a collection agency.
• Assess late-charge penalties.
• Implement a policy that states in order to continue charging on an account, the monthly bill must be paid regularly.

Table 3: Example of Inventory Analysis Sheet

Table 4: Effects of Discounts on Cost of Goods Sold

CASE EXAMPLE 4: GROSS MARGIN AND EXPENSES

Pharmacy A: The pharmacy owner realizes that the gross margin on prescriptions has been decreasing over the past few years. The pharmacist reviews her third-party contracts and decides not to renew the ones that are paying less than AWP-10 percent + $3. She also begins to pursue other specialty niches that have higher gross margins and attends a compounding continuing-education program at the local college of pharmacy.

Pharmacy B: The pharmacy owner realizes that the gross margin on prescriptions has been decreasing over the past few years. The pharmacist complains about the poor third-party reimbursement, but believes that she must accept these plans to keep traffic coming into her store. Furthermore, she believes this is a competitive environment where she must accept all plans and keep prices low for the cash customer. She does not pass on the manufacturers' price increase to her customers.

Discussion: This example illustrates the importance of improving gross margins. The gross margin is the difference between the sale price and the cost of the item. To improve gross margins, one can increase the price or decrease the product costs. The sale price should pay for the cost of the product, the dispensing costs (or other expenses), as well as a profit. If the product cost is increased by the manufacturer, management must consider passing this cost on to the customer.

The sale price may depend on a third-party contract. Again, it is essential that pharmacists review third-party contracts before participating in the plans. The third-party contract should be evaluated to ensure that the reimbursement will indeed pay for the cost of the product, the dispensing costs, as well as a profit.

Product costs can be decreased by selecting a competitive wholesaler/supplier, participating in buying groups, and by obtaining discounts, as previously discussed. The pharmacy owner or manager should consider deleting product/service areas that do not produce an acceptable gross margin and adding product/service areas that do produce a higher gross margin. Examples of products and services that have been associated with higher profit margins in community pharmacies include generics, compounding, immunizations, herbal/nutritional products, and durable medical equipment.

Equally important is decreasing expenses to improve cash flow. If overall expenses decrease, there will be fewer bills to be paid and, hence, less cash going out of the business. To reduce expenses, saving such as finding lower interest rates, reviewing rent agreements, outsourcing tasks, or evaluating supplier options must be found. Table 5 provides five tips for reducing expenses.

Table 5: Five Tips for Reducing Expenses

Determine the ideal number of employees by comparing your needs during your slackest times with your average day. Hire only enough staff to meet minimum needs and yet not compromise service. It is less expensive to pay overtime than to have additional, unneeded staff on the payroll. Involve your staff in attempting to reduce expenses. Reward them for ideas that reduce expenses. Evaluate the cost of facilities. If renting, compare rent, consider signing a longer lease for a lower price, or decrease the amount of space you occupy. If you are the owner, you may want to consider refinancing for a lower rate or a longer term to reduce your monthly payments. Renegotiate Fees form outside advisors (e.g., lawyers, accountants, bankers). You may want to hire them on a retainer-basis only. Also, shop around for cheaper insurance; however always use an A-rated company and know what you are buying. Evaluate the use of your utilities. Contact the local utility companies to determine if you are on the best "plan." Screen out unnecessary long-distance telephone calls. Network. Ask colleagues how they reduce overhead and keep their experiences to a minimum.

CASE EXAMPLE 5: INVESTING

Pharmacy A: The consultant reviews the balance sheet for this pharmacy and questions why over $100,000 is in the checking account. The pharmacist explains that he likes to have the money accessible at all times.

Pharmacy B: The consultant reviews the balance sheet for this pharmacy and notices that over $100,000 has been invested into several short-term certificates of deposit.

Discussion: Recall that cash flow is affected by operating, financing, and investing activities. Cash flows in and out from investment activities. Pharmacy B provides an example of how investing can affect cash-flow efficiencies. The extra money the pharmacy has earned is being used to generate additional cash through investing. Alternatively, the owner of Pharmacy A is not receiving additional benefit from having this extra cash. Additional cash in-flow is not occurring because of his decision not to invest the money.

Financial Ratios

Computing financial ratios is the first step in the financial analysis process. Ratios are typically compared to some figure for interpretation. The NCPA-Pharmacia Digest is an excellent source to compare financial ratios. One can also use "rules of thumb" as estimates as well as internal comparisons (i.e., comparisons of past performance). Good managers typically utilize a combination of the above methods to obtain a more accurate and useful picture of their company's financial performance. Although there are several financial ratios that can indicate the financial health of a company, only a few that pertain to cash flow will be reviewed here. The NCPA-Pharmacia Digest provides additional information on how to calculate these ratios.

Test of Profitability

Tests of profitability indicate the company's ability to cover its expenses and earn profits. One example is the gross margin percentage that measures the profitability of the company before expenses are considered. A subpar gross margin would indicate low prices, improper purchasing, or theft. This ration can indicate where the manager could focus and improve cash flow.

Tests of Liquidity

Tests of liquidity indicate the capability of a pharmacy to meet its current obligations or liabilities with current assets without impairing its ability to operate. The most common ratio used to test liquidity is the current ratio. The current ratio is defined as current assets divided by current liabilities. It indicates the extent to which the pharmacy will be able to meet its short-term liabilities with assets that are expected to be converted to cash within the year.

For independent community pharmacies, the current ratio should be between two and four. Lower than two means that the pharmacy may have trouble paying its debts on time. A current ratio greater than four would mean that, perhaps, the pharmacy is not utilizing current assets to generate revenue. For example, there may be too much inventory on hand, too much cash in the bank that is not being invested to generate interest, or too much in accounts receivable.

Another indicator of liquidity is the accounts-payable collection period. The accounts-payable period measures the time it takes for the pharmacy to pay its creditors. The ratio indicates the average number of days between purchase on credit and payment for purchase. In the past, the "rule of thumb" was between 24 and 30 days. However, because many pharmacies pay their wholesalers at least twice monthly, this time period has been shortened.

An accounts-payable collection period that is very short may indicate the pharmacy is paying its bills too quickly, increasing the amount of cash flowing out of the business. A period greater than 30 days may indicate that the pharmacy is probably paying it bills too slowly and, in turn, may be losing money die to late charges or the loss of cash discounts.
Tests of Solvency

Tests of solvency describe the pharmacy's ability to meet its long-term debt obligations without impairing normal operations. A common ration used to test solvency is total debt to total assets, Ideally, this ratio should be around 0.5, indicating that the pharmacy owns at least 50 percent of its assets. Younger pharmacies may have higher ratios since they have had little time to pay off debt incurred at startup.

Tests of Efficiency

Tests of efficiency demonstrate the pharmacy's ability to efficiently manage resources. One efficiency ratio is the inventory turnover rate (ITOR). The ITOR describes the efficiency with which inventory is used. It measures how quickly inventory is purchased, sold, and replaced.

According to the 2000 NCPA-Pharmacia Digest, the average ITOR for an independent company pharmacy equaled 8.8. If the ITOR is too low, then the pharmacy may be carrying too much inventory or inventory that is not sellable. Hence, cash is being spent to purchase the inventory, but no cash is flowing in from sales. If the ITOR is too high, it may indicate that out-of-stocks may be incurred too frequently, resulting in irritated customers and a loss of sales.

The accounts receivable collection period is a second indicator of efficiency, measuring the length of time it takes the pharmacy to collect the sales made on credit. Because the pharmacy does not receive the money right away on these sales, the pharmacy is financing these purchases. Credit may boost sales and operating profits; however, it puts more money in accounts receivable and, thus, hinders cash flow. Table 6 provides an illustration of the effect of different collection periods on pharmacy cash flow. Note, that if a pharmacy's charge sales averages $100 per day, then reducing the collection period form 60 days to 30 days frees up an extra $3,000.00. This money can then be used for other purposes, such as paying bills or building inventory.

A third efficiency ration that is similar to the accounts-receivable collection period is the outstanding credit sales ratio. Between 28 and 45 days is generally accepted, but it should be as low as possible. Longer periods indicate poor credit management and poor cash flow.

Table 6: Effect of Different Collection Periods on Pharmacy Cash Flow

Summary

When making financial decisions, pharmacy management should evaluate all three financial statements and consider all internal and external factors. One valuable source of information is the cash-flow statement. Using cash-flow statements, pharmacy owners and managers should evaluate the sources and uses of cash in their pharmacy. Managing inventory, accounts payable, operation expenses, accounts receivable, and investments will improve cash-flow efficiency, resulting in a more successful business.