The Practice Purchase Initial Analysis - A Case Study Part 1
Wes Read walks through buying a dental practice by analyzing the seller's financials. He reorganizes expenses into six categories, explains healthy overhead ratios (60% overhead, 40% owner income), and shows two valuation tests: price-to-collections (70-90%) and price-to-earnings (1.75-2.75x).
Chapters
Welcome back, associates. So now we're going to dive a little bit deeper into stage one of the practice purchase process, the profitability and asking price review. Now, we're going to divide this up really between two modules. This first one, we're going to look at things as at more of a high level to help you understand where we're trying to arrive at. What's the goal in doing this initial analysis and asking price review. And then our next module will be taking a deep dive into an example of a practice that's being sold and how we'll actually apply a process to arrive at what we're going to see here in this module. So I want to start with the end in mind, in other words. Now, when you're going to buy a dental practice, ideally the seller would come to you and the seller would give you financial statements that look just like this, and maybe for multiple years, but look just like this, where you have your practice collections, you have your expense categories, you have your total expense, and you have the difference between your collections and your total expenses, also known as your overhead, to get. What's your operating income? That number right there, your operating income is what we're trying to sort of sift through all the garbage. When we get these financial statements from a doctor, they have all this fluff, they're not organized, they're not very clear to arrive at. Okay, what's the true profit of the practice? For me to pay for my debt, to pay for my taxes, to pay for my personal budget, to pay for my savings? What is that number? Well, it's not an easy number to get to. And so you got to take the financials and you got to essentially sift out the garbage, repackage them, and give it in a format that you can easily interpret. It's like going from one of those old black and white X rays to having like a CT view where you can just look at it in a much more crisp way. Well, that's what we're trying to do here. So ideally you would get in this format and you can see in this practice it's a 1.35 million in net collections. And that's going to be after refunds to patients. So net collections and then you have your expense categories. Now, we've explained this in a couple modules, but I want to quickly do it again. The way that we as dental CPAs segregate out, at least the way we do it here at practice, CFO segment segregate out, your profit and loss statement is between six Categories of expenses. Now, within each of these six categories, you can get a lot more granular. And our financial statements do. But these are sort of groups. And the first group is your labor. And your labor, you're going to have hygiene assistant, front office, you're going to have payroll taxes, maybe some benefits in there. And that would all be broken out on our profit and loss statement. But ideally right now we're just wanting to see what's your total labor cost. And in this case it's $379,000. What are your total supplies? In this case, 110,000. That's number two, supplies. Number three are labs, number four is facility, number five is marketing and number six is admin. And you'll see when we talk about extracting yourself from the dependency on PPOs, you'll talk about why marketing is so important such that.
We need to look at the way we're marketing online versus mail marketing your website cost, pay per click. It's important that you be very granular about that. And so under marketing you might have those different categories. But marketing, you should know how much you're spending in marketing and have a good plan for that. A lot of marketing knowledge is sort of money thrown into the wind if you're not careful about that. But if you use it right, marketing can be one of the most important investments, I'll say, or expenses on your profit and loss statement. Now you'll notice that there is a percentage next to each of those. So Your labor is 28% of your collections. That's actually a pretty healthy rate for a general dentist. 28%. Your supplies are 8%, might be a little bit high. Dental labs at 10%. So you can see the healthy ratios. And what I'm saying, whether it's high or healthy is you can see those healthy ratios over there on the right. Ideally we would have a 60, 40 ratio. 60% of your collections go to pay overhead, which by the way does not include you, the doctor, this is just your staff, your supplies, lab, facility, marketing and admin. 60% and then 40% stays for you to pay yourself and your debt and your savings and your taxes. Now where is this doctor a little bit high. Well, labor by 1% perhaps. Supply is by a couple percent. Lab by 1%, their facility cost by 1%. Marketing is actually a little bit under. And then administrative costs over by 3%. So it's little bit of a spread across the different categories of overhead are causing this doctor to be about 7%. Too much of their collections is going into Overhead. Now, this can be different a bit by region. So if you're here in San Diego or Southern California, sometimes your labor costs and your facility costs are a little bit higher than in, say, rural Pennsylvania or some other areas of the country. So take this one as just a general rule of thumb here. So you look at this and you say the doctor is only at 33%, but at the same time, 1.35 million. That's a healthy practice. And so the net operating income at 439,000, that's not too bad, even though it is only 33% of the, of the income, as opposed to a healthy practice, a really healthy practice, going to be 40% or maybe even a little bit more there. So just on surface, I look at that practice and I rate it as a decent practice. So now we have to look at that 439,000 and say, what does that mean for you? Taxes and debt and personal expenses. So I'm going to talk about that in our next module when we get into the example of a sample. Dr. Devlin is the doctor's practice that we're going to look at. So at the end of the day, we're trying to answer these questions. Number one, should we buy this practice? And now we covered this in the prior module, should we buy this practice? What we're really saying is, do we like the cash flows out of that practice? Is the operating income strong? And number two is, is the price reasonable? And what is a reasonable price? Well, a reasonable price is when you take the price divided by the revenue or the collections of the practice price divided by annual collections. And if that number resides around 70 to 90%, then it's within a healthy range. And again, this is a little bit unique to areas just like housing. Housing costs in Southern California are going to be different than housing costs in Utah or Arkansas or some other place. But by and large, that's the rate. That's the, that's the range that we're looking for. So if your annual collections are a million dollars collections and the asking price is 800,000, then the price to revenue is 80% falls right smack in the middle. That could be a reasonable price. Could be, we got to do our due diligence, of course, but it could be. And then number two, because that's priced to collections, collections are up at the top, the 1.35 million. Let's now look at it relative to the profit, which is the 439,000. So after expenses, because it could be a practice doing. I don't know, $10 million a year, but if there's zero operating income, I don't think I'm going to want to buy that practice for nothing. A lot, a lot of questions could go into that. But let's look at a top line and bottom line, as I say. So bottom line, we use this ratio called price to earnings. What is the price divided by the earnings? So in our example of a price of 800,000, the earnings are 439,000. You'd say 800,000 divided by 439,000, and that's going to be a little bit under 2, in which case it's probably falling within that ratio pretty well of 1.75 to 2.75. So that's just to give you a preliminary analysis of what we're trying to accomplish when we get these financial statements from the seller, where you get the prospectus from the seller. And we need to shuffle the numbers around to get to the point where we can see is the price reasonable and what is the true operating income of that practice. Okay, next segment of the Associates on Fire program is we're going to dive into that example and I'll tell you right now that I'd love for you to go to mod to the resources on our website, Fuel cell number three. So click at the top. Resources, go to fuel cell number three. You've got to create your profile, your account and add your profile to get access to the resources and unlocks them. And then you can go to the Dr. Devlin income statement Normalization resource. You can download that. It's a PDF and I am going to highly recommend that you attempt to go through it on your own before watching the the Next Segment video, in which I will explain exactly the logic or the flow of thinking as we go through that to decipher whether that's a healthy practice for the buyer or not.
