A Guide to Financial Decision Making

As physician leaders, we make financial decisions all the time. These decisions aren’t necessarily hard, but they can be stressful and complicated at times. This stress and complexity can keep us from making the best decision possible. Here’s a guide to help you make better financial decisions.

An Algorithm to Follow in Financial Decision Making

The very first step in the algorithm is identifying your mission and purpose. What is your business all about? What is it that you do and why do you do it? Answering these questions will serve as a guide for the rest of your decision-making process. It will be your guiding light and help you stay focused on what’s really important. What are your core obligations? What are your duties as a firm and practice?

The next step is to ask, "What is the issue you’re facing?" Is it an opportunity to invest in growth? Or, is it an opportunity to remove an underperforming asset? Sometimes you’re presented with an opportunity to grow and move closer towards your mission and purpose. Other times, one of your current assets might be holding you back from achieving your mission and purpose. Knowing which scenario you’re dealing with is essential as you begin the decision-making process.

Next, evaluate the actual cost of the opportunity. What will this opportunity cost your organization? What's your cash outlay? How will you be financing it, if necessary? Will you take on debt or bring in more capital? If you’re taking on debt, how much will you pay over the life of the loan? If you’re raising capital, what form will that be? What are the different types of financing available to you? Make sure you fully appreciate all of the financing possibilities available to you.

After you’ve performed this analysis, you’ll want to compare it to your hurdle rate. A hurdle rate is a combination of your capital return and the cost of your debt. It’s the average of the interest rate on your debt and what your shareholders expect as an annual return on their money. Usually, you’ll want the investment to be at least equal to this hurdle rate. If the investment doesn’t meet your hurdle rate, you should eliminate it as a possibility.

You can perform other investment calculations such as net present value (NPV) and the internal rate of return (IRR). These are more complex calculations but can easily be done with Excel or a financial calculator. I discuss these calculations in greater detail in my book, The Financially Intelligent Physician. Check it out if you want to learn more.

Next, you’ll want to evaluate all your options. What are your opportunity costs? Every decision you make comes with an opportunity cost. When you say yes to something, you are saying no to something else. Do you know what those other things are? It’s important to understand what you are saying no to as well as what you’re saying yes to.

Understand What a Sunk Cost Is

One of the most significant impediments to any financial decision-making process is sunk costs. Sunk costs are costs that are sunk. They are costs that have been incurred but are unable to be recovered. It’s money you’ve spent and cannot get it back. It’s like buying something at a going out of business sale, and all sales are final. You cannot return it and get your money back.

By realizing what a sunk cost is you’ll be able to avoid the sunk cost trap. The trap is the tendency to irrationally follow through with something even though it’s not meeting your expectations because of the investment you’ve made. This investment can be either time or money or both. Have you ever sat through a horrible movie just because you paid for the ticket? That feeling is an example of the sunk cost trap. It’s best to recognize your emotions surrounding your investment of time and money when making financial decisions. If you don’t, you may very well get caught in the sunk cost trap and lose even more time and money.

Summary

Financial decision making can be stressful, so always do what you can and remain calm. Gather all the information possible about all of the opportunities you’re facing. Know your mission and purpose. Understand what your organization's goals are and how these opportunities will help you achieve them. Understand your options and expected outcomes. And finally, recognize if you’re in the sunk cost trap. It’ll keep you from making the best and most rational decision for your organization.