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Books & Benchmarks

How Do Financial Statements Impact a Practice’s Valuation? Part 1

by | Dec 9, 2023

If you’ve ever purchased or sold a practice, you know that practice valuations can be both intriguing and nerve-wracking. You might find yourself asking, “What’s the value of my practice?” or “Am I paying too much to acquire this practice?” Then you start looking at the practice’s financials and you may start wondering: how exactly do these help inform my decision? 

When it comes to determining the value of a business, financial statements play a crucial role. They impact practice value in two ways. The first is obvious. To determine the financial value of a business, you need financial data about that specific business. But the second is more subtle: a business with clear reporting is less risky than a business that can’t clearly demonstrate its results.   

In many valuations, there are only two inputs: a benefits stream and a multiplier (which is directly related to risk). We’ll discuss benefit streams (financial data) piece this week and tackle risks next week. 

Benefit Streams 

While historical results are essential to understanding the business, the real value lies in future expectations. As you consider the quality of your financial statements, here are three big things a savvy evaluator looks for while reading them. 

  1. How much is the owner earning? This can be harder to determine than you’d think. For starters, is the payroll split between owner(s) and employees (and also ideally split between associate ODs and non-OD staff)? And are payroll taxes and benefits also allocated to owners and employees? Are personal expenses run through the business buried in the expenses or are they re-classed as distributions? It is incredibly difficult to forecast future earnings when past earnings aren’t clear. 
  1. Is it easy to assess overhead?  Books & Benchmarks uses the 7 Key Expense Areas pioneered by Dr. Jerry Hayes to assess and benchmark practices’ overhead and profitability. It’s tedious to have to re-organize a financial statement, especially if Cost of Goods items like Contact Lenses and Optical Lab are scattered throughout an alphabetical list of expenses. Whether an expense category is low, high, or normal, getting a clear picture of historical expenses is critical to assessing future expectations of overhead and profitability. 
  1. Are there missing or mispriced expenses? Sometimes, the expenses currently reflected in your practice financials aren’t the same as they will be when your practice is owned by another party. This shows up in two main areas, although there may be others as well. 
  • Rent. Once a practice owner pays off the mortgage on their space, they may stop charging the practice rent altogether. This can distort the P&L profits when a future owner reads them because the current owner WILL charge rent to someone else. In other cases, the owner may charge the practice above-market rents because the tax treatment of the real estate entity is favorable. Or they may charge below-market rent to preserve practice cash flow. 
  • Wages. The wages of a practice owner are almost always adjusted when valuing the practice, either because they are well below or well above the cost of replacing the owner’s patient care hours. The trickier situation is when family members are involved. Does the spouse on the payroll actually work for the practice? Sometimes that wage needs to be adjusted out because it only existed to fund a retirement plan. Other times, a spouse worked for the practice at an unrepresentative wage. It would be best if you talked with your CPA and CFP about this, but we recommend paying the working spouse a fair market wage for their role. 

Timely, Accurate, and Meaningful Financial Statements Matter 

As you get closer to retirement, it’s wise to tighten up your financial reporting so potential buyers can clearly understand what they’re buying. However, having strong financials is important at every point of your career because tragedies and emergencies do happen. We’ve seen multiple situations where a doctor either dies or is suddenly injured and urgently needs to sell. But the sale is delayed by weeks or months because the selling practice cannot provide current financials to potential buyers. 

This brings us to the importance of getting your financial house in order. It not only helps buyers assess their income potential as owners but also reduces the perceived risk when considering a potential purchase. If you have any questions or need help evaluating your practice’s valuation, don’t hesitate to reach out to our experts. Stay tuned for part two next week, where we’ll dive into the topic of risks.

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