Purchasing the Practice

The Dental Practice: A Management Simulation Chapter 3 – Purchasing the Practice

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3 Purchasing the Practice


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Simulation Scenario

Congratulations! You are about to purchase a dental practice. The practice belongs to Dr. Ivan. M. Olde, a dentist who is retiring and moving out of town for his golden years. Dr. Olde was longstanding practitioner in the community. The Community Dr. Olde has practiced in the same location for 35 years, which is in a growing area of the city. A cross section of patients in the area very closely matches the general demographics of the country. There are two major employers in the area - an auto assembly plant, which employs approximately 12,000 people, and a small appliance assembly plant, which employs approximately 3,500 people. Its major products include conventional electric ovens, microwaves and window air conditioning units. Large corporations own both plants. The employees have excellent benefits including health and dental plans. The auto plant has recently laid off a few workers. Some concern exists about the poor labor relations at the plant. The local media has talked of a major retooling by the corporation to turn this plant to robotics, although many workers consider it a management threat with the purpose to cut wages. The appliance manufacturer enjoys generally good relations with its workers, although wages and benefits are not as good as the automaker’s. Besides the major employers, there are many smaller manufacturing and service firms in the area. Most of these either service the major employers or relate to local paint and chemical concerns. A growing economic sector in this city has been data processing for banks and insurance claims processing. Unemployment in the area typically runs a little lower than the national average. The population of the immediate practice area consists of a stable mix of young and older blue-collar families, with a large scattering of singles in several upscale apartment complexes. The major recreational activities of the locals include local college sports, fishing, and bowling. The arts are also well represented for a city of this size. The educational level for this city is average for the country. The major causes of death are cardio-pulmonary related conditions. There is a mix of ethnic and religious (predominantly independent Christian, with large Catholic and Presbyterian groups and smaller Jewish, Hindu, and Muslim) populations in the community. Many of the practice's patients have one or more family members who work for one of the major employers. Approximately 65% of the total patient base has some form of third party payment plan. A small but significant portion of the population qualifies for Medicaid. An equal number of affluent people live in the outlying areas and suburbs. Several smaller manufacturing concerns subscribe to a regional capitation plan for its workers' dental benefits. Another group of chemical related industries subscribes to a national CDO (PPO) plan. Together, these plans account for a growing portion of the local third party dental market. Dr. Olde practices in a state that has restrictive expanded functions and hygiene delegation laws. The dental provider supply in the area is about average for the country. Several new dentists are struggling, but if they can "stick it out" for several years, the situation usually improves. One or two local dentists have "gone under," in the last several years, but most people attribute that to the belief that they never really did "fit in" the local community. The city fluoridated the local water supply approximately 55 years ago. During that time, the dental community has been supportive of fluoridation and has been very active in local health fairs, school screenings and other public health measures. The local dental society has been the leader in developing many of these community based public health projects. They have also developed a free clinic for migrant farm workers and homeless families in the area. Volunteer dentists and staff members work in this clinic on a rotating basis. The Practice Dr. Olde’s practice consists of three dental operatories, which are equipped with old, but serviceable equipment. The office is small, although the space immediately behind this office is vacant and the landlord has said you can expand into that space anytime. He employs three people. Laverne is a chairside assistant who has worked for him for the past fifteen years. She has agreed to continue


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working for you, since you seem like a pleasant young dentist. Patricia is the receptionist. She is middle-aged, and married to a factory worker. She works with the office computer program, but prefers paper and pencil to computer bytes. Shanda, the hygienist, has worked for Dr. Olde since she graduated from hygiene school, about three years ago. Dr. Olde has a traditional view of the profession of dentistry. He believes that dentists should remain professional rather than business oriented and is concerned with the evolving trend away from traditional private practice. He was openly thrilled when a large shopping center retail dental practice closed recently, even though he feels he lost only a few patients to the center. His practice is "mature," and he does virtually no external marketing. He accepts several insurance plans, although he complains frequently about them. He has always seen a few Medicaid patients and participated in the free clinic, feeling it is his duty to give back to the community and the profession that has been so good to him. Dr. Olde originally provided a complete mix of services to his patients. As the practice grew, he stopped doing most extractions and endodontic procedures because of the complications and after-hours calls. The number of new children in the practice has also dwindled. Dr. Olde now tries to concentrate the practice primarily on restorative and prosthetic work. He refers periodontal and orthodontic cases before the reconstructive phase and does not have an active recall program. He has had more patients than he needs, since he has been slowing for several years. The office is small, but well-furnished and well-appointed. His equipment is in good working order, although it needs to be upgraded. The business office is adequate, although Patricia has always wished that it were larger.

Initial Practice Evaluation You need to do a complete assessment of this practice to decide if you will purchase it. This is known as due diligence. In the real world, you will hire a practice transition consultant to help to be sure that you are making good business decisions. In our simulated world, you have hired a transition consulting firm (Robb & Pillage, Practice Consultants) who has provided you with a report giving the estimated value of the practice and other details. You can find this report on your web site (Consultant’s Purchase Report). The rest of this chapter describes the methodology of preparing that report. Review this information carefully. You will be asked at the end of the simulation to compare your practice to this initial practice for your Report to Your Banker. (Your Game Administrator may use this as an educational assessment tool, and may include it in your graduation portfolio as evidence of your understanding of practice management concepts.) In our exercise, your consultant will prepare a report that contains the following sections:

1. Analyze and adjust last year’s income statement for the practice 2. Perform an initial practice ratio analysis 3. Determine a value for the practice 4. Estimate how much you will need to finance to purchase the practice 5. Estimate your total monthly and annual payments 6. Project your cash flow for the first year (working capital needs)

Successful business owners need to keep their fingers on the financial pulse of their business operation. Therefore, you will need to do some “number crunching” make these determinations. You will not examine every possible number associated with the practice, but instead will look at some “key metrics.” These are also called “financial ratios” by many business people. These numbers are used as indicators of the health of one area of the practice. If the indicator doesn’t meet standard, then you can dig deeper into the numbers to find the source of the problem. As you review the analysis, think beyond the calculation itself - remember why your consultant is making the calculation. If you know


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what the result will show or be used for, you will take a huge step to becoming a successful business owner. There is an example report at the end of this chapter. The actual consultant report for your practice is on your web site. Your Consultant’s Purchase Report contains the following sections: 1. Analyze and Adjust the Income Statement You will be buying the income generated by the practice. To be sure how much income there is, most consultants “normalize” the seller’s income statement. When you normalize, you adjust the statement for any special or unusual business practices the owner used. Normalization removes these special considerations so that all income statements are the same (or normal). In this way, the statement is a statement of the cost of operating the practice as a true, cash business. You will have the same expenses to report as the seller. Remove any items that the seller really used for personal reasons, such as auto expenses. The seller may arrange tax or other business affairs for tax savings or asset protection that would show only on a normalized statement. For example, if the seller owns the building and does not charge himself rent (thereby increasing apparent profit), you should enter a fair market rent into the adjusted statement. Conversely, if the owner owns the building but charges the practice an abnormally high rent to shift income to another entity, then you should reduce that to a general market rent value for the office space to determine a true (normalized) profit. The owner’s spouse or children may have been listed as working in the practice for tax reduction reasons. These amounts are added back into the profit. If the family member provides needed services without compensation, then you will need to normalize the statement by adding a reasonable compensation for those services. Depreciation and interest expenses are also removed, because these are asset acquisition costs, not operational costs. The Consultant’s Purchase Report on the web site details the specific items that they have to adjust the income statement. These items are listed in the “Practice Sale” section. They have added or subtracted the adjustments from the reported annual amounts (in the “Adj” column) to determine an adjusted amount for each category, and the total statement. 2. Perform an Initial Practice Ratio (Metric) Analysis Your consultant will perform a series of financial analyses on the practice, using the adjusted income statement. In doing this, they compare this practice to national or regional norms. You want to decide if the practice is healthy, and to define areas of the practice that you might need to change performance. The results might identify areas that will cause you to pay less for the practice, or see areas that you believe will allow you to improve profitability. For example, say that your consultant finds the new patient ratio is very low. This might indicate that either the practice is slowing down, or that you will need to spend a considerable amount for marketing expenses to increase new patient visits. Regardless, in this case you would discount the price you are willing to pay for the business. The chapter on practice metrics (ratio analysis) in the student manual (Section 8) gives a detailed procedure for a complete analysis. Use that material to learn the specific techniques for each of these analyses. Here, your consultant does these few basic tests to check practice health. If a ratio is out of standard, it is described it in the “Assessment” column. You may use it later to justify a higher or lower price for the practice. Net Production This number tells you how much money the practice generates for the period. Net production is the gross production (at full fee value) minus any discounts, adjustments, or amounts that you have agreed not to collect. Net production should increase over time. Overhead Percentage This tells you how well the practitioner controlled the costs relative to the gross production. If the


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overhead ratio is high (above 65%), either costs are too high relative to production, or production is too low relative to costs. Most of the time, a new practitioner will initially have a higher overhead ratio due to interest expenses, buying new equipment and materials, and slower practitioner speed. Managed Care Percentage This ratio tells the level of managed care insurance involvement in the practice. Higher levels drain profit from the practice, which means that you will need to work harder for a given income expectation. Some well-established practices may have little or no insurance plan involvement. In this case, check to be sure that the patient pool has not aged too much with the practitioner. Collection Ratio The collection ratio describes how well (overall) the practice collects the money that is owed. This is reflection on the front office staff and the credit and collection policies that the seller has set. It is closely related to the accounts receivable amount. Typically, practices collect 97% - 99% of their net production. Accounts Receivable Amount The accounts receivable amount tells you how quickly the practice collects the money that the patients owe. To compensate for different size practices, look for a ratio of about one month’s net production. You can tighten credit and collection policies, but most experts recommend that you do this over time. You don’t want to offend the patient pool that you hope will stay with you. New Patients per Day The new patient number tells you how well the seller has generated new patients for the practice. A low number (below one per day) may indicate a need to increase marketing efforts and expenses. Recall Effectiveness This ratio assesses how well the practice manages their recall function. You want to see about 90% of the recall patients due being actually seen in the period. A low number may indicate a problem in either the hygiene area, or in the business office, if they are responsible for scheduling recall visits. Capacity Utilized Capacity utilization tells how well the practice used its productive resources (equipment and staff). If fewer than 80% of the appointments are filled, there are too few patients for the practice resources. This may be from a scheduling problem, too much expansion, too many employees, or a lack of patients. If this number is above 95%, then the office may consider expanding, changing staffing, or becoming more efficient. 3. Determine the Value of the Practice When we value a dental practice, we are deciding an estimate of the price to purchase that practice as a business. We can borrow methods and techniques from other types of business transfers and apply them to our situation. Most of these methods determine the income stream from the business, estimate how much of that stream will transfer to the new owner, then place a value on that transferred income stream. So what you buy is the expectation that you will make a certain income from the profit. If a practice is losing money, then the current owner literally should pay you to take this losing proposition off of his hands. When we value dental practices, the specific methods are a bit different from other businesses for several reasons. First, the number of potential buyers for dental practices is limited. Some states require that all owners be dentists. Other states do not have this requirement, but the potential group of buyers is still limited by lack of understanding of the dental business world. It is much easier, for example, for someone without special knowledge to operate a sandwich shop than a dental practice. Due to professional licensing requirements, non-dentist owners still must hire dentists to work in a dental practice. The business’s customers (patients) often develop close personal relationships with


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the providers of care, so the incoming and outgoing dentist’s personalities affect the number of patients who stay with, or leave the practice. The practice value amount is not a magic number set in stone. It is a starting point for negotiation. As in most capitalistic ventures, the laws of supply and demand govern the transaction. If this is a highly desirable practice that has many people considering purchase, then the buyer may pay a premium for the practice. Conversely, if the practice has been on the market for some time without any serious inquiries, then the buyer has some price leverage, and may well negotiate a lower price for the practice. The seller may have to accept this lower price or wait a very long time to find another potential buyer. When we purchase a dental practice, we buy four classes of assets. We will usually value these assets separately and report these amounts to the IRS. You then may arrange separate loans for some of them. Your consultants have provided a value for Dr. Olde’s practice in section 3 of the Consultant’s Report on the web site. It contains estimates of the following values. Hard Assets Hard assets are the tangible items that you purchase in the business. These include dental chairs, equipment, computers, reception area furniture, and all of the other items involved in doing the dentistry or running the business. (You buy dental equipment, but only to the extent that you can use it to generate an income.) While there is no “blue book” to value used equipment, a dental supply company can easily value them. One of their representatives will develop, for a reasonable fee, a detailed listing of everything to be sold and an estimate of the fair market value of those assets. (The seller should provide this.) Some accountants use a “book value” (purchase price – accumulated depreciation) method to value equipment. This method is a bit problematic in that it depends on a reasonable purchase price and a reasonable depreciation method. (Fair market value is the more common method.) The current owner needs to sell you those assets “free and clear” of any liens, loans or other encumbrances. If the current owner owes money on any of the assets of the practice, it is his or her problem to pay off those loans. The amount remaining on the loan does not enter into the value of the asset or practice. If they take a loss on the transaction, it is their problem. You are not there to bail them out of their previous bad business decisions. Hard assets are usually a small portion of the total value of a dental practice. If you need to immediately update equipment, then you should add the expected amount into the practice loan, later. If this makes the loan amount greater than the banker is willing to finance, then use the old equipment until you have adequate cash flow to show that you can handle the additional loan amount. In this exercise, Dr. Olde has had a dental supply representative develop a list and value for the hard assets of the practice. The value is given to you in Section 3b (Value of the Practice) on the Consultant’s Valuation Report. Soft Assets Soft assets are things of value in the practice that you cannot pick up and hold in your hands. These include items such as the use of the same telephone number, the information contained in the patient data base, a covenant by the seller to not compete with you, and the good history and reputation of the selling dentist. These are often combined and called the “ongoing concern value” or the “goodwill” of the practice. Some consultants will parse out the various components (goodwill, use of the telephone number, patient record information, restrictive covenant, etc.). However, for our simplified analysis we will consider them all to be included in the “soft assets.” Where hard assets are easy to value and a small portion of the overall practice value, soft asset can be difficult to value and represent the majority


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of a typical sale. There are several common ways that transition consultants use to value them. They often use a weighted three-year average of each method. We use a simplified method in this exercise. The first method is to use a percentage of the net production (or collections) of the practice. Net production is gross production (at full fee value) less adjustments required for insurance or other programs. This method assumes that most well-run dental practices will have a similar cost structure and overhead ratio. They will, therefore, show similar profits. Typical percentage multipliers are in the range of 50% to 65% of annual net production. Exceptionally desirable practices may be valued higher. Your consultant assumed that the average practice goodwill in your area sells for 60% of net production. A second method to value soft assets looks at the net income of the practice. This method says that you don’t care how much dentistry the practice produced, you are buying the income stream (profit) from that production. This assumes that you will have similar costs as the seller. The one year adjusted income is then used as an estimate of the goodwill value of the practice. Exceptionally desirable practices may carry a premium goodwill value of up to 125% of adjusted net income. It is probably not surprising that this number is usually very close to the net production estimate, after applying the percentage above. Your consultant estimates that the goodwill sells for approximately 1.1 times adjusted net income in your area. The third common method is to use a comparable sales method of valuation. This method looks at what similar practices have sold for. This is like a real estate agent looking for comparable houses (“comps”) in the neighborhood to establish the price for your house. Many practice brokers and consultants belong to a professional organization that helps to track sales of professional practices for this purpose. Your consultant has provided a value from comparable practices in his report. Your consultant used the three methods given to estimate the value of goodwill in this practice. He then averaged the results of the three methods to come up with one final estimate of goodwill. Financial Assets Financial assets include accounts receivable, cash (in the checkbook, change, or petty cash funds), and deposits for utilities or other reasons. In most buy-out situations, you will not buy any financial assets. The owner will be responsible for collecting his or her accounts receivable. You may collect them for the seller, charging a “reasonable fee,” often 10% of the value. If you do not buy accounts receivable, then you will need to borrow more working capital for the practice start-up. If for some reason you must buy the accounts receivable, then a rule of thumb is to pay 80% the value of all accounts 90 days-old and less, and pay nothing for accounts older than 90 days. (For these older accounts, you will pay as much to collect them as you will gain from them.) Buying AR has the advantage of you needing less working capital, but you now have the problem of collected the former owner’s accounts. You will borrow working capital to meet your immediate cash needs, including this in the practice loan. In the buy-in situation (forming some type of partnership), then you generally will buy a proportional share of any assets of which you will be a part owner. For this exercise, Dr. Olde will be responsible for collecting his accounts receivable. You will not purchase any financial assets. You therefore will certainly need to borrow additional working capital. Real Estate Not all practitioners own the practice building. Many lease the space. If the seller owns his or her own building, they may want to sell this real estate. Other sellers prefer to retain the real estate as a form of ongoing income. Depending on the situation, a banker may not be willing to loan money for the practice and real estate. Rather than offer too much debt, they may want you to buy just the practice, then later, when you have proven the profitability of the practice, they will lend for the real estate purchase.


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Dr. Olde owns the building, but he does not want to sell it to you at this point. He has agreed to lease to you for five years under reasonable terms (the amount given in the report). To value the entire practice, simply add the adjusted value of all of the asset classes. Use your ratio analysis to either increase or decrease the starting value, determining the amount that you are willing to pay for the practice. 4. Calculate the Amount of the Practice Purchase There are two major practice components that you will finance. They are listed below. Bankers will usually include these in one loan. If, for example, the practice costs $300,000, and you estimate that you will need an additional $40,000 for equipment upgrades, then the total loan amount will be $340,000. If you buy the real estate, then that is a separate loan that has a longer associated term. Notice that this does not include working capital. If you need working capital, it will increase the loan amount. Practice Price Your consultant previously determined the price that you will offer for the practice. Equipment Upgrades Much of Dr. Olde’s equipment needs to be replaced or updated. You have spoken with a dental equipment representative and his estimate for the needed upgrades is listed in the “Amount to Finance” section of the Consultant’s Valuation Report. This is in addition to the existing hard assets that Dr. Olde will sell. 5. Estimate the Total Payment Amount The monthly amount that you will pay on your practice loan depends on the principal amount, the interest rate, and the term (or length) of the loan. Most practice loans are set at five to seven years. If you have a lot of student debt, your banker may let you extend the loan payments to ten years. This decreases the monthly payment for the practice, allowing you more easily pay student loans.

Monthly Payment on a Loan per $1,000 Borrowed

2% 3% 4% 5% 6% 7% 8% 9% 10% 12% 15% 20%

1 84.24 84.69 85.15 85.61 86.07 86.53 86.99 87.45 87.92 88.85 90.26 92.63

2 42.54 42.98 43.42 43.87 44.32 44.77 45.23 45.68 46.14 47.07 48.49 50.90

3 28.64 29.08 29.52 29.97 30.42 30.88 31.34 31.80 32.27 33.21 34.67 37.16

4 21.70 22.13 22.58 23.03 23.49 23.95 24.41 24.89 25.36 26.33 27.83 30.43

5 17.53 17.97 18.42 18.87 19.33 19.80 20.28 20.76 21.25 22.24 23.79 26.49

6 14.75 15.19 15.65 16.10 16.57 17.05 17.53 18.03 18.53 19.55 21.15 23.95

7 12.77 13.21 13.67 14.13 14.61 15.09 15.59 16.09 16.60 17.65 19.30 22.21

8 11.28 11.73 12.19 12.66 13.14 13.63 14.14 14.65 15.17 16.25 17.95 20.95

9 10.13 10.58 11.04 11.52 12.01 12.51 13.02 13.54 14.08 15.18 16.92 20.03

10 9.20 9.66 10.12 10.61 11.10 11.61 12.13 12.67 13.22 14.35 16.13 19.33

15 6.44 6.91 7.40 7.91 8.44 8.99 9.56 10.14 10.75 12.00 14.00 17.56

20 5.06 5.55 6.06 6.60 7.16 7.75 8.36 9.00 9.65 11.01 13.17 16.99

25 4.24 4.74 5.28 5.85 6.44 7.07 7.72 8.39 9.09 10.53 12.81 16.78

30 3.70 4.22 4.77 5.37 6.00 6.65 7.34 8.05 8.78 10.29 12.64 16.71


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To find the amount of monthly payment, use the chart given above. Your banker will use a computer program that gives a more exact number, but this estimate will be within several dollars of the exact amount. Find the annual interest rate column, and the term in years in the appropriate row. Find the factor where the two intersect. Then multiply that factor by the number of thousands of dollars you will borrow. For example, if you will borrow $300,000 for 7 years at 8% interest, find the factor where 8% and 7 years meet (15.59). Multiply this by 300. (You are borrowing 300 times $1,000). This gives $4,677 per month payment. Multiply this by 12 months to find an annual payment of $56,124. (You can also use this table to calculate home mortgage, car payments, or any other regular series of loan payments.) Principal amount is the Amount to Finance from above. The interest rate is found on the Initial Values form on the web site. The term (in years) is found on the Initial Values form on the web site. The factor is found on the chart below. The monthly payment is the factor multiplied by the number of $1,000 dollars you borrow. The annual payment is the monthly payment multiplied by 12. 6. Project Cash Flow and Working Capital for the Practice You will need money to pay immediate bills while the business becomes profitable. Bankers call this working capital. As a rule of thumb, dental practices need about three month’s adjusted expenses in working capital. Your consultant has prepared a cash flow projection for the practice (section 6). This is just the cash you will need to begin the practice. You may need to borrow additional working capital if you expand the practice or if the practice grows more slowly than you anticipated. Initially, money flows into the practice more slowly that it flows out. Insurance payments take time to process, and patients may be on payments plans or “forget” to bring their check book. However, employees and suppliers want to be paid on time. The cash flow analysis calculates the difference so that you can borrow enough money to cover this start-up period. To make this decision, you need to project your cash needs for the first year. Note this is only an educated guess about how well you will do. The following chart is an example of doing this technique. Your consultant used the numbers from Dr. Olde’s last quarter as your starting point (Quarter 0). He then used his experience with previous transitions and the following calculations to estimate your cash needs for the practice. He then added in an estimate of your office loan payment, and an estimate of your personal expenses to arrive at the total cash need. (This projection is for illustration only. The actual cash flow projection for this practice is on the Consultant’s Valuation Report on your web site.)

Projected Cash Flow (Example)

Item Qtr 0 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Year 1

Office Net Production 100,000 110,000 121,000 133,100 146,410 510,510

Office Collections 100,000 77,000 117,700 129,470 142,417 466,587

- Office Cash Costs 75,000 75,000 75,000 75,000 75,000 300,000

Operational Cash Surplus 25,000 2,000 42,700 54,470 67,417 166,587

- Office Loan Payment 0 15,000 15,000 15,000 15,000 60,000

- Personal Expenses 0 25,000 25,000 25,000 25,000 100,000

Total Cash Flow 25,000 -38,000 2,700 14,470 27,417 6,587

Cumulative Cash Needs 0 -38,000 -35,300 -20,830 6,587


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Office Net Production The first step is to estimate your net production for each quarter. Good practice transfers will show at least 90% patient retention. Be sure to take into account for growth that you anticipate. Remember, net production is your gross, or total production, minus any adjustments (e.g., insurance programs). For this example, we estimate that you will keep the same initial level of production, and will increase net production 10% each quarter after. Office Collections Next, you want to estimate what your collections will be for the upcoming year as a result of the production. We know that we will not collect all of the money owed us, and the money that we do collect will come in slowly at first. For our simplified cash flow analysis, we make the following assumptions:

Qtr. #1: The first quarter, estimate that you will collect about 70% of your net production (from Quarter #1). The remainder will be in accounts receivable and collected the following quarter.

Qtr. #2: The second quarter, plan on collecting about 70% of net production from Quarter #2, and

the remaining uncollected amount (30%) from Quarter #1. Qtr. #3: The third quarter onward, plan to collect 70% of the net production from the current

quarter (e.g., Quarter #3) and 30% from the previous quarter (e.g., Quarter #2). In our example cash flow projection, Quarter #1 collections are $77,000, which is 70% of $110,000 net production. Quarter #2 collections are 70% of Quarter #2 net production and the remaining uncollected amount (30% of $110,000) from Quarter #1. This assumes that you will collect 100% of the amount due from patients and insurance companies. If the practice had a low collection ratio (high uncollectible amounts) you can adjust these values accordingly. Office Costs You have the historical cost numbers from Dr. Olde’s practice. (Use the annual numbers from the Practice Valuation Worksheet “Income Statement” section, since these have been adjusted to show cash expenditures.) Change them to reflect any changes that you will make, such as adding employees. In the example cash flow projection, office costs are $75,000 per quarter. You believe that they will remain steady through the first year. Operational Cash Needs This is the estimate of your cash needs to operate the practice for the quarter. If it is negative, then you have a cash need for operations. A positive amount indicates a cash surplus. Office Loan Payment You have recently determined how much you need to borrow. Calculate the quarterly amount of the loan payment. (One quarter equals three months, or one quarter of a year.) In the example, the loan payment is set at $15,000 per quarter ($60,000 per year). When you complete your cash flow projection, you will have an actual amount of loan payment, as determined in Step 5 above. Remember to convert monthly payments to quarterly payments for the cash flow projection. Personal Expenses Many new business owners include a modest living expense for themselves in working capital. Your personal expenses are an important factor in deciding if you can make this “deal” work. This is one reason your banker will probably require a family budget as part of the loan application process. Personal expenses include living expenses, personal taxes, and student and consumer loan payments. Each person brings his or her individual needs to this decision. If you are married to a professional person who can support the family budget, then your personal needs will be less. If you graduate with no student debt, you obviously have a different need form a classmate who has considerable student


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debt. Is this “fair”? That is debatable. But it is a real consideration. Your Game Administrator has determined an annual amount to use for personal expenses. Find it in the Practice Valuation Worksheet, Banking Information section. Here we estimate it to be $100,000 per year (pretax), or $25,000 per quarter. Total Cash Flow Determine cash flow for each quarter by subtracting office costs, loan payment, and personal expenses from office collections for each quarter. Hopefully, you will show excess cash flow (a positive number) each quarter. Early in a practice life cycle, it is common for the practice to show a negative cash flow for several quarters. Expenses come in faster than payments for service. This leads to an increase in accounts receivable. Eventually, payments for service catch up with the expenses, and the practice shows a positive cash flow for the quarter. Cumulative Cash Needs This line keeps a running tally of the total amount of cash that you need for the first year. Add the current quarter’s cash flow to the previous quarter’s cumulative cash needs. If a quarter has a cash shortage, the cumulative cash need becomes larger (more negative). The smaller the cumulative cash needs, the more “wiggle room” you have if projections are not exactly as planned. You might find a cash need for the first quarter or two, but should turn that into positive cash flow by the end of the first year. The working capital that you borrow is to cover cash flow shortages. If the cash flow is greater than the working capital, you need to either borrow more working capital, or cut down on expenses. You could do this by decreasing personal spending, or extending the loan term (if the banker agrees) to lower loan payments. If the cash deficit is too great to work with, you may need to walk away from the deal. This carries huge personal, financial, and professional consequences. In our example cash flow projection, we see that in Quarter 1 the practice showed a small profit. Due to the needs for loans repayment and personal income, there is a total cash deficit for the quarter. Quarter 2 shows a larger profit, as accounts receivable catch up with production. There is a small cash surplus even after loan payment and personal expenses. However, the cumulative cash need is still negative, as you begin to pay down the large initial cash deficit. Production and profit continue to increase in Quarter 3, and the cash surplus is larger. The cumulative cash shortage continues to decrease. Quarter 4 finally shows a cumulative cash surplus for the quarter. Over the first year, this practice shows a total cash need (greatest cumulative negative amount) in Quarter 1 of $38,000. This then is the minimum working capital the buyer should arrange. Arranging for more (say $50,000 or $75,000) would give a cushion if the estimates come up short. Remember, must borrow additional money to cover any estimated initial cash needs.

Finishing the Deal After your consultant helps to investigate the practice, you should talk with a banker (or several bankers) to insure that you will be able to finance the deal. Each banker has slightly different needs in the paperwork that you will present. Some call for a complete business plan with detailed cash flow projections. Others have a simplified process. In larger, regional or national banks, the banker will need to get approval from the bank’s lending committee before giving you any money. You will be a highly valued client, so bankers may be willing to work with you to gain your business. So be sure to shop around for banks. You may get a better deal at a competing bank. In our scenario, you make Dr. Olde an offer of the amount you have calculated. He accepts the offer. Your banker has agreed to lend you the entire amount needed to purchase the practice. This amount includes the hard assets of the practice, the "Goodwill" of Dr. Olde's long established presence and excellent reputation in the community, and money for equipment upgrades. In addition, she has extended you a line of credit for working capital (start-up costs and future loans for business reasons),


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bringing the total of the loan package to $300,000. The loan is a variable rate loan at "prime plus 2%," adjusted quarterly. If you exceed the loan amount, the banker will extend your line of credit, but due to the added risk (for the bank), the interest rate will be set at “prime plus 6%, for any amount above $300,000, also adjusted quarterly.


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Documents

Purchasing the Practice