Do a 'financial physical' on your practice
By Terry Flanagan, DC, DABCO, MPH, MBA

Buying or selling a professional practice can be stressful. You'll always wonder if you are getting a good deal.

With a close look at how the practice operates, you can figure out if you got a good deal by finding out what the practice is worth.

Think of the practice as a living, breathing entity that has risk factors (the operating structure), vital signs (the financial ratios), and wellness factors (the management structure).

One way to determine a practice's value is to evaluate the practice the same as you assess the clinical status of a patient. In other words — to come to a conclusion about the overall health status, first evaluate the current condition.

RISK FACTORS

How the practice operates on a daily basis gives you important information on its health. Consider referral sources, location, practice demographics, competition, income efficiency, operating efficiency, and staff efficiency.

Evaluate each of these, using the assessment form in the sidebar, "Evaluate the practice's operating structure."

VITAL SIGNS

Just as a patient's vital signs give clues to respiratory, circulatory, and cardiac health, a business' vital signs give clues to its financial health.

These financial vital signs are called ratios. They give insight into the business' ability to meet its short-term and long-term financial responsibilities. The ratios also indicate if the business is overloaded with debt and is in danger of not being able to survive the future.

Physical vital signs are compared against the health industry's "gold standard" in the same way you measure blood pressure (120/80). Financial vital signs show how the practice stands in relation to its peers.

Financial statements commonly used to develop business ratios are the balance sheet and income statement.

Balance-sheet and income-statement financial ratios are determined by dividing a specific financial item by another financial item. A short list of common ratios and industry benchmarks include:

• Current ratio = current assets/current liabilities. The industry ratio is 1.2.
• Quick ratio = (accounts receivable + cash)/current liabilities. The industry ratio is 1.0.
• Receivable turnover = net sales/average accounts receivable. The industry ratio is 15.5.
• Coverage ratio = (net pre-tax income + interest)/interest. The industry ratio is 8.0.

Other financial ratios are presented as a percentage of operating income. In this case, the ratios are developed by dividing the category by the total amount of the operating income:

Industry averages for a number of these ratios are:

• Cost of operations/operating income = 10.9%
• Advertising/operating income = 1.4%
• Doctor's compensation/operating income = 13.3%
• Operating margin/operating income = 3.4%
• Depreciation/operating income = 1.3%
• Employee benefits/operating income = 1.5%

WELLNESS FACTORS

The management structure of a practice is easily compared to the wellness factors a physician would look for when evaluating a patient.

Wellness factors are a combination of healthy activities undertaken with a focus on positive short-term and long-term outcomes. Management activities that strengthen the practice structure reduce its risk and act as stabilizers during the up and down fluctuations of the normal business cycle.

Evaluate the practice's wellness factors by using the assessment form in the sidebar, "Assess the practice's wellness factors."

Areas that will make the practice healthier are, coincidently, areas that also make the practice more valuable through increased profitability and ease of management.

As you rate the practice's operational health, consider your answers from a "franchise" type of scenario. The value of a franchise is largely based on the strength of its operational system because the operating system continues to work effectively and efficiently, even during personnel changes.

A clinic's operating system is the supporting framework of the business and should also be able to work effectively as a stand-alone function. This is especially important during a transition from one physician to another. Poor systems and old technology create a riskier step for a new buyer and have less value when compared to a progressive, well-run clinic.

Better systems lower overall risk and improve the health, and therefore the value, of the practice.

Just as a patient's lifestyle can influence a large amount of control of his or her health status, the individual physician's "operational lifestyle" can exert a large amount of control in determining the going concern value of a practice. Creating a practice that has high value takes planning and an understanding of the interrelationship between the various building blocks.

A practice with strong operational-value drivers will improve the bottom line, create a more valuable practice to sell, and be a healthier practice to buy. And just as you tell your patients, reducing the risk means a better chance of a long and productive life.

HOW TO INCREASE VALUE

You do not have to settle for current value. You can do a number of things to increase the practice's value.

1. Review and upgrade your office operating systems. Electronic billing systems and computerized patient records are not "the future." They are "the present."

2. Train your staff and make staff training an ongoing priority. A professionally trained and versatile staff is a valuable marketing tool.

3. Perform an annual financial physical on the practice. Compare your results with the industry.

4. Diversify your patient and payor mix. Multiple sources of patients and income should be attractive to you and will be attractive to a buyer.

Terry Flanagan, DC, DABCO, MPH, MBA, is an accredited valuation appraiser (AVA) and is accredited by the Institute for Business Appraisers (AIBA) for business valuation. He is a principal of Circumference, a company that performs financial valuations for buyers and sellers of practices. He can be reached at TerryF@aol.com.