One of the most daunting four-letter words for any chiropractor—especially those with smaller practices—is the word “debt.”
Not surprisingly, the tightening of credit, reduced sources of capital, and general skittishness on the part of lenders, has made avoiding debt easier for the principals in small practices.
But is operating and growing a debt- free practice really practical?
Debt can best be compared to “leverage,” because borrowed funds help many chiropractors grow their practices using someone else’s money. Despite its negative connotation, even the healthiest of corporate balance sheets will include some level of debt.
In reality, a DC’s practice typically has two financial resources for growth: debt and equity. Raising equity requires the practice to sell ownership interests—if permitted under local licensing regulations. Debt, on the other hand, allows the practice to obtain the funds needed to grow and operate by borrowing it.
Bottom line: Debt can be extremely advantageous and a useful tool for any practice. The benefits of debt include:
Maintaining ownership: When funds are borrowed from a bank or another lender, the sole obligation is to make the agreed-upon payments on time. But that is the extent of your obligation to the lender; the practice can be run as you see fit without outside interference.
Building credit: Practices with good credit histories usually have an easier time establishing credit with suppliers, eliminating up-front payments and the personal liability of the practice’s principal or partners.
Deducting taxes: Because borrowing funds or incurring debt in most cases results in a tax deduction, it is hugely attractive. Usually, the interest portion of the loan repayments can be deducted on your practice’s tax returns as an expense.
Lowering interest rates: Tax deductions also have an impact on interest rates. For example: If a lender is charging 10 percent for a loan, and the government taxes the practice at a 30 percent rate, there is an advantage to tax deductible loans. Take the interest rate and multiply it by the tax rate, which in this case is the 10 percent interest rate multiplied by the 30 percent tax rate, which equals 7 percent. In other words, after tax deductions, the practice is paying the equivalent of a 7 percent interest rate.
Increasing cash flow: Practices generally incur debt such as loans to create cash flow. And creating cash flow can be critical during seasonal slow periods. At times, there may be a gap between income flowing into the practice and bills coming due. Debt can be a useful tool in filling this gap.
Obviously, there are also drawbacks to debt financing, including:
Repayment: As mentioned, the practice’s sole obligation to the lender is to make payments. Unfortunately, even if the practice fails, payments must still be made. And if the practice is forced into bankruptcy, the lenders will have a repayment claim before any equity investors.
High interest rates: Even after calculating the discounted interest rate from tax deductions, the practice may still be faced with a high interest rate—if it can find a lender. Interest rates will vary due to economic conditions, the practice’s history, the practice’s credit rating, and the principal’s personal credit history.
Credit rating impact: While the assumption of debt when your practice needs money can be seemingly attractive, each loan will have an impact on your practice’s credit rating. The more that is borrowed, the greater the lender’s risk and the higher the interest rate charged.
Cash and collateral: Even where a loan is needed to acquire an important asset, the practice must ensure that it will generate sufficient cash flows to repay the borrowed funds. And don’t forget the collateral often required to protect the lender should the practice default on its payments.
Lenders usually want installment payments to begin shortly after funds are borrowed. Thus, to begin making those payments, the practice will need cash. Unfortunately, since even a thriving practice may find itself short of cash at times, every borrower should ask: Are the borrowed funds to be used for fixed or variable assets?
If the money is to be invested in a fixed asset such as equipment, near- term cash is unlikely to be generated. If the funds are for a variable asset, such as inventory, supplies, or costs associated with new patients, then the debt should generate needed cash flow.
What are my patients like? Patients who consistently pay on time are critical to cash flow. Learning the payment habits of patients and considering incentives such as discounts to get them to pay early are important. Also, check with associations and competitors to ensure your practice’s payment terms are in line with industry standards.
Where is my practice in its lifecycle? In the early stages of a practice, debt financing can be risky. In all likelihood, a new practice will lose money at first, making loan payments difficult. Also, as net income will be low, the tax advantages of debt will likewise be minimal. As the practice grows and matures, debt becomes a stronger option. The tax advantages will be greater, cash flow more predictable, and the risk posed by bankruptcy lessened.
Measuring it all
While it is true that borrowing enables a practice to take actions or grow at a pace that might otherwise not be sustainable, it can also result in a less flexible operation. After all, the more the practice borrows, the more it must spend on debt payment and interest. But how much debt is too much?
Lenders love to analyze ratios that let them to see how a practice is doing and compare it to other practices they’ve loaned money to. Ratio analysis is also a useful tool.
How healthy is your practice? Basic ratio analysis may tell the story. Your financial ratios allow you to check your practice’s current temperature, diagnose potential problems, and see if you are doing better or worse over time.
Consider the “total debt ratio.”
The name says it all; the total debt ratio shows how much the practice is in debt, making it an excellent way to check the operation’s long-term solvency. The formula is:
Total debt ratio = total debt/total assets
These numbers can be taken from your balance sheet and plugged in. To illustrate, a practice with $22,375 in total assets and $25,000 in total debt would have a total debt ratio of $25,000/$22,375 = 1.11-to-1.
Thus, this practice has $1.11 in debt for every dollar of assets. Obviously, the total debt ratio reveals this practice is not in good health and may become gravely ill. For good health, the total debt ratio should be 1-to-1 or less.
While you may find becoming debt-free to be intimidating, the evidence shows that during economic downturns the less debt a practice has, the greater the odds of survival. And when the economy is looking brighter, the debt- free practice is often in the strongest position to take advantage of opportunities.
Becoming a debt-free practice can be a lengthy process. While there are no guarantees in life, it is certain that the owner of a small practice will sleep better at night knowing that the debt- free business is stronger and more secure in these uncertain times.
Unfortunately, for the majority of practices that choose to be debt-free, growth tends to be slow.
For more than for any other reason, practices fail from a lack of cash. And most practices need capital. While today credit is an increasingly available resource, it must be used wisely.
Debt can be paid off when the practice is ready to stop growing. Until then, the practice should leverage all possible funding resources for investment in the operation. If you ignore debt as a practice tool, it could hurt your prospects for growth.
Mark E Battersby is a tax and financial adviser, freelance writer, lecturer, and author located in suburban Philadelphia. He can be reached at 610-789-2480.
DISClAIMER: The author is not engaged in rendering tax, legal, or accounting advice. Please consult your professional adviser about issues related to your practice.