The Practice Purchase Initial Analysis - A Case Study Part 1

Okay, this One is the Dr. Devlin activity module.

All right, associates, we're going to take a deep dive into the analysis of some sample financial statements that you might get from a seller as you're considering buying that practice. This is perhaps one of the most important modules and activities in the entire Associates on Fire program. So I'd like you to take the time to follow along and actually attempt to do the activity module yourself. Not just listen. You're going to understand it and remember better when you attempt to do it first yourself and then come back and watch this video. Now, we're going to divide this up into a couple modules so it's not so lengthy. But what I would do first, as I mentioned at the end of my prior module, is to go to our website, associatesonfire.com, click on Resources at the top, make sure that you've created a login and filled out our Associates on Fire profile. And then it will unlock the resources and go to fuel cell number three in the resources and find the Dr. Devlin Income Statement Normalization Module. Download it as a PDF and attempt to complete it beforehand. It even has the answer key in there as well. And if you've gone over the answer key, great. But I'm going to go over this verbally with you right now. So here we go. Let's do this. Here are the assumptions of Dr. Devlin's practice. He is selling his practice. Doesn't matter why, doesn't matter his age. We just know he he's selling his practice right now. Now, in reality, you'll probably want to find out why are you selling your practice. Is there something wrong with it that he or she doesn't want to explain? But for this analysis, we're just looking at the numbers. So here are the assumptions. Number one is we have a profit and loss statement, also called an income and expense statement. Same thing. Or you're P and L if we want to keep it short. Your profit and loss, your P and L. And it says see below. And it's going to be on the next module. What the profit and loss statement is now your combined tax rate. Again, this is you buying it. I want you to put yourself in the shoes of the buyer. After you buy it, you're going to be in a 30% tax bracket. Now, depending on your state and how much income you end up having, that will fluctuate up or down. But let's say you're at 30%, a reasonable number. If you're in California, probably a little bit higher, since state alone is 10%. And let's say the asking price of this practice, Dr. Devlin or his broker is asking for 1.1 million. And the annual debt payments, if you paid 1.1 million at a certain interest rate, maybe we have 4%, I'm not sure. But at a certain interest rate, you're going to pay $10,000 a month or $120,000 per year for that $1.1 million practice. Now, if you watched our student loan module, you know that when you make a debt payment, it is broken out between principal and interest. Every payment. Some principal, some interest, assuming it's not interest only, which really doesn't apply to dental practices other than maybe an initial term to sort of entice you to take a loan from a certain bank. But generally speaking, these are fixed amounts of debt payments you pay every month on that loan that you took out to buy the practice. And it's divided between interest and principal. In this example, the assumption is that of the 120,000, 50,000 is going to interest. I'm keeping my number simple here. 50,000, which means how much is going to pay the principal or, or pay down the loan in that first year? 70,000. 120,000 total annual payments less the 50,000 that went toward principal equals 70,000, which is going toward, I'm sorry, interest. The 50,000 that went toward interest and leave 70,000, which went toward principal. Now, in the industry, as I mentioned in my prior module, when a practice is sold, generally speaking, a healthy rate or range of practice valuation is going to be 70 to 90%. And I gave a few examples there, and we'll see. What is Dr. Devlin's practice? What number is it at for his practice? And then you have price to earnings, industry ranges. And just like think of a house in an area, the amount of the lot size in the square footage dictates a whole lot of the value of that house, probably more than anything else. Well, same thing in dental practices. What's the collections and what are the profits? And that generally dictates what is the cash flow and what the value is of that practice. And Those are the two healthy market comparisons is 70, 90% for the price to revenue and 1.75 to 2.75 for the price to earnings. Now, let's look at Dr. Devlin's picture. P and L, if you printed out that PDF from our resources. Got that in front of you. Great. Have a pen or pencil, get ready to write down some things if you haven't done this fully already. This is a classic example where you get a profit and loss statement and it has your collections at the top has refunds and your total income. Now in this case, the collections are 1.4 million. And patient refunds during the year were $50,000. And at the end of the year, at net of the patient refunds for the whole year, the doctor had $1.35 million of income. So that 1.35, that is in our ratio price to collections price divided by collections of 1.35. That's a fairly easy number to calculate. Now we want to get also to price to earnings. And notice our net income is $67,000. Is that the true earnings of the practice? Question of the day, the answer is absolutely not. That is what QuickBooks spits out as the net income after all the expenses are put in there. But there's a lot of fluff that's going on here, a lot of reconfiguration we need to do to convert that $67,000 into what is the actual operating income of that practice. And notice here we have all the expenses in alphabetical order. A, all the way down to T, total expense. I mean, all the way down to U for utilities, where in the prior module I showed you how we want to repackage that so we know what our labor costs are, what our labs, what our supplies are. So as you go through the process of what's called normalizing the income statement, and that's what you're doing is you're repackaging these numbers into that simplified version of total income. Less overhead, which is labor, lab supplies, facility marketing and admin. And what's your operating income, which is the difference between your collections and your overhead? That's what we're trying to get at here. So what we need to do is go through this and decide what do we need to take out. Now, if you're talking to a broker or you're talking to the seller who sort of follows this language, they're going to use this term called add back. What do we have to add back or take out this financial statement that we're looking at right now? Because it doesn't, it doesn't apply to you. For example, if the seller has a. The seller's super aggressive and doing probably what they shouldn't do. Let's say they're running their pool guy or girl through the practice checking account. Are you going to pay for their pool guy or girl? Absolutely not. So we need to sift that out. That's called an add back. And so we take that out. Now here's the list of the various add backs. I have a in our resources printout, I have a table that you can write back the add backs and that's what I want you to do right now. If you haven't done that, I want you to write in that table. And you can see this on my screen. The left gray column is what do you think we need to add back or sift out of the P and L to arrive at the true profitability. In other words, what's personal and unique to the Doctor that you will not inherit when you buy that practice. So go back to the financial statements and look at all those expenses and what do you think we should add back? Now one other tip I want you to keep in mind is it's not all or nothing. Sometimes you might have office supplies that are partially true office supplies, like some ink for your printer or some sticky notes and things like that. Those are true office supplies. But when the doctor is running all their Amazon through their corporation, most of that stuff's going to the personal house for personal use.

So it can be a hybrid, both business and personal. So what I want you to do is write all those that you believe can be added back at least partially or fully in this list and then let's decide how much we really want to add back so we can arrive at the true business expense. So go ahead and pause the video and do that right now.

Okay, I'm going to now go through this with you. And here we go. Let's go to the P and L. And I've put a red arrow by all of those that are extremely common to have add backs automobile expenses. The doctor's automobile, the seller's automobile, that's their automobile. You're going to have your own. And you may or may not run it through the corporation. Even if you do, it's still going to be a different cost. So we want to add that back. It's not a true business cost. Then we have continuing education. It's very common that doctors will be perhaps excessively aggressive at times and run their family ski trip through the business because they met with a friend who lives in the neighborhood and called that continuing education. Or they did a online CE while they were there in the cabin at the ski resort and called it a continuing education. Now we talk in our tax modules about where the line is and crossing that line. I'm not going to get into that here, but just know when you're getting numbers from sellers, you're going to commonly See that? And notice continuing education costs. There are $40,000. It's probably quite excessive unless he's doing some big implant training and paying a lot of money for it. So you got to take that with a grain of salt. Dr. Meals and entertainment as well. We're going to add that back. The doctor's salary. Now there's a big one. Why are we adding back the doctor's salary? You might be thinking, well, I'm going to have to pay myself just like the seller did. Yes, but how much an owner pays him or herself has nothing to do or shouldn't with their own production and has everything to do with their own tax planning and retirement 401k planning. And so in order to compare apples to apples, to get to operating income, you have to take out the doctor's pay.

And then later we'll figure out what your pay is, but you have to take out the doctor's pay. So doctor's salary, take that out now. Also, if the doctor's family is on payroll, you're also going to want to remove kids and spouse off of here as well. Unless the spouse is actually, say, working in the front office. Then we may want to keep that in there. Even if they're not going to be in there. After you buy the practice, you're going to have to hire somebody to replace the spouse and there's going to be a cost associated with that. So you got to normalize that. In some cases, you may need to actually add an expense here if we're going to pay the replacement more money. I hope you're following this now better of what we're trying to accomplish is we're trying to create a profit and loss statement that's going to mimic or that's going to represent what your cash flow look like after you buy the practice. So interest expense, we take out interest expense. Why? Because you're going to have your own debt. Remember, this is an asset sale. You're just buying the assets. You're not assuming the debt of the seller. So we don't care what the seller's interest expense is. So we take that out. Medical services, you're going to have your own health care premiums, for example. We actually have that down a little bit lower. Like. But medical services, really out of pocket. Medical expenses should not be run through the corporation at all. It's not deductible. It's not a business expense. The IRS is very specific about that. This doctor maybe did it and took a tax deduction or not. I don't know, but we got to pull that off. Office supplies. There's my example. $30,000 in office supplies. Really, Doc? All right, how about pension expense? Got to pull that off because that's the 401k. Most of that is going to the doctor's own retirement. So we're going to pull off the 401 and, and you may or may not do a 401k early on. Usually you gotta time that to do it at the right time. So we're gonna pull that off. Payroll taxes. Now, payroll taxes. Some of Those taxes of 30,000 are going to pay the staff payroll taxes, but some of it's also to pay the doctor's own payroll taxes. So a portion of the payroll taxes needs to come off as an add back as well. Any personal insurance, we're gonna take that off. Personal disability insurance, personal medical insurance. Now we'll keep malpractice on there because you are going to have a malpractice insurance that probably going to be somewhat similar and we keep that on there. If his or her malpractice insurance premium is a lot greater or less than yours, we might have to do some normalization there and then go back down and we get to travel and lodging. 40,000. Again, you and I both know that that is not a true business expense. So we need to add at least a portion of that back. So now let's go to our list and here's everything I've written down. Now there's no way that you're going to know everything, particularly on the partial add backs. So just, just bear with me and follow my logic on that and what I'm trying to teach. The add backs are all of those red arrows. The ones that are fully added back are the automobiles, the doctor salary, the interest expense, the medical services, the 401k, the disability insurance and the personal medical insurance. The other ones are partial add backs because it portion of that category is legitimately a business expense. So what are the total add backs end up being? If you add that all up, that second gray column, $372,000. Now go back and look at the profit and loss statement for a sec. It was $67,000 was the net income before the add backs. So 67,000 plus the sum of the add backs of 372,000 is.

$439,000. Now we get to the true profitability of the practice that the buyer will have to pay the buyer's own needs, their personal expenses, their taxes, their debt and their own savings. And, and any of that sort of fluffy stuff that you run through the practice, like office supplies and travel and meals in your car and that kind of stuff. The 439 has to pay for all of that. So now it becomes a personal financial analysis to make sure that that's going to cover all of that. We know the debt alone was 120,000. So right there, alone of that 439,000, 120,000 of that right at the top is going to pay the bank. So then you're left with 319,000 to now pay your taxes and your student loans, your personal living and your savings and all of that. Again, personal financial analysis to make sure that's enough. Now we're going to end the module here and in the next module we're going to carry on in our initial analysis of, of this practice to determine is the price reasonable, number one, and number two, how much are you actually going to take home after overhead, debt and taxes? To answer that question, from a cash flow standpoint, does it make sense? And then ultimately I'm going to define what is your true income. And I'm going to give you a little bit of a spin on how I define true income and as a practice owner. So stay tuned for that. It's going to be exciting. Looking forward to it.