Up and Up and Up: Accounting for Supply Cost Inflation in Due Diligence
January 16, 2024
Written by Johnny Zizzi, CPA, and Melissa Hoelting, CPA
In the dynamic world of healthcare mergers and acquisitions (M&A), decision-makers need to understand the intricacies of historical spend normalization and cash-to-accrual conversions for accurate financial analysis. One often underestimates the impact, but a critical factor in this process centers on accounting for supply cost inflation. As companies enter into transactions, they must consider how fluctuations in supply costs impact historical financial data and, subsequently, their future financial outlook. In an era of high inflation, financial due diligence takes on a new level of complexity and significance for businesses and investors alike. The impact of soaring prices and rapidly changing economic conditions can significantly affect the accuracy of financial assessments, making it imperative for financial professionals to adopt unique strategies and considerations in their due diligence processes.
Inflation-Adjusted Financial Analysis
In high inflationary periods, traditional financial metrics may lose their relevance. Businesses should prioritize inflation-adjusted financial analysis to obtain a more accurate picture of a company’s performance. Historically, healthcare inflation has outpaced overall inflation. Medical and surgical supply costs have steadily increased over time. From 2017 to 2021, average medical surgical supply costs increased by 6.5% each year. From 2019 to 2020, the increase in these supply expenses was approximately 3% before the more rapid increase of about 10% in 2021. With these significant increases and fluctuations, advisors must be able to recalculate key financial indicators and assess a company’s ability to maintain profitability and manage costs.
Source: KaufmanHall, 2023
Cash to Accrual Impacts
Converting financial statements from a cash basis to an accrual basis can significantly impact the quality of earnings, particularly when dealing with supply cost inflation. Under cash accounting, expenses are recognized only when cash changes hands, which can distort the true financial picture when supply costs are rising. To convert supply expenses on a cash basis, advisors typically begin by calculating monthly reported supply costs as a percentage of monthly revenue. Then, depending on the frequency of supply purchases, the average percentage of the last six to 12 months becomes each month’s adjusted supply cost percentage. However, with rising costs, advisors might need to reduce the lookback below six months regardless of the purchasing patterns, as using older data could result in understating supply costs for the most recent months. Thus, a financial due diligence team becomes essential in transactions with rising supply costs, as the cash-to-accrual process becomes more complicated and requires an in-depth analysis and conversation.
Robust Forecasting and Scenario Analysis
Rising labor expenses, growing inflationary pressures, declining admissions, and intermittent supply chain disruptions have placed significant pressure on profit margins across the healthcare industry. Through the mid-point of Q4 2022, the median hospital operating margin equaled (0.5%) as compared to 4.0% during this same period in 2021.
As inflation and supply chain uncertainties continued throughout 2023, forecasting and scenario analysis are paramount because they enable businesses to proactively manage the financial impact of rising costs and make informed decisions. This proactive approach allows companies to adjust pricing strategies, negotiate better contracts with suppliers, seek alternative sourcing options, or implement cost-cutting measures—all of which are vital for maintaining profitability and ensuring business continuity in the face of supply cost inflation.
If a company begins these steps before any potential transaction, it sets itself up for potentially favorable pro forma adjustments to offset any historical inflation. However, the key to receiving credit for these changes comes from having proper support and evidence of a downward trend in price, such as current invoices, signed contracts, or cost-per-volume analysis. Ultimately, instituting the results of forecasting and scenario analysis can serve the dual purpose of mitigating the adverse effects of inflation on current performance and providing an avenue for potential upside adjustments in future transactions.
Net Working Capital Analysis
Net working capital analysis takes on heightened significance in accounting for supply costs during times of high inflation within the context of a quality of earnings analysis. As supply costs rise, they can impact a company’s balance sheet, affecting both assets and liabilities. For example, inventory values may increase due to higher supply costs, potentially inflating total assets. Meanwhile, accounts payable may also rise as the company incurs additional liabilities for unpaid invoices related to these increased costs. Advisors must align the timing of cash flows associated with assets and liabilities to mitigate liquidity risks stemming from supply cost inflation. Additionally, the typical 12-month lookback may be inappropriate in times of rising costs, as older periods will not reflect current and future market conditions. As a result, many transactions shift towards a three- to six-month lookback to set the price/earnings-to-growth (PEG). In times of rising prices, the due diligence team’s role becomes even more essential: Determining the balance sheet impact of market conditions requires careful consideration.
Conclusion
Healthcare M&A is undeniably dynamic, and the ability to navigate its intricacies is contingent upon a deep understanding of historical spend normalization and cash-to-accrual conversions, as well as the nuanced impact of supply cost inflation. The rising tide of inflation has placed an exceptional level of complexity and significance on financial due diligence for both businesses and investors in healthcare. To tackle these challenges effectively, we have highlighted the importance of inflation-adjusted financial analysis to provide a more accurate depiction of a healthcare organization’s performance in the face of escalating costs. Transitioning from cash to accrual accounting methods and employing pro forma adjustments are vital tools for enhancing the quality of earnings analysis in the healthcare landscape. Moreover, robust forecasting and scenario analysis, as well as vigilant net working capital management, are fundamental strategies in addressing the complexities introduced by supply cost inflation. As increased inflation shows little signs of subsiding, the role of financial due diligence in healthcare transactions becomes even more vital in addressing the current market conditions’ added complexities and considerations.
