Aug 18, 2016
How to Analyze a Dental Practice for Sale – The Quantitative Factors
Written By: Brian Hanks
Recently, I was approached by a dental student with financial papers in hand wanting to know “Is this dental practice I’m thinking of buying a good one?”
“It depends,” I replied, “on what you want. Do you have student loans and want to be able to pay them off quickly?”
With a touch of “duh” in her voice, she replied “yes”
My next question was, “Do you want to retire when the average dentist retires today at 68.8 years old, or would you rather have the freedom to walk away earlier in your 50’s if you wanted to?”
Horrified, the student replied “That’s the average retirement age?!”
Feeling a little bad about bursting her bubble, I continued, “does this practice collect enough, and have enough profit to support your debt pay down, savings and lifestyle goals?’
“….um….I’m not sure…” was the response. We talked for a few minutes about how much she wanted to make and when she wanted to be debt free.
From there I took a quick glance through the financial documents she had and, focused on six or seven numbers. Within a few minutes I had a pretty good idea of whether or not this student was considering a financially “good” practice.
What are those numbers?
I’ll outline exactly what to look for in a practice you’re considering purchasing.
Key Number #1 – Collections – The foundation of whether or not to purchase any practice has to be collections. There simply must be enough money coming into the practice to justify the time, stress, and incredible expense you’re going to take on as the owner of a practice. We recommend clients look at practices that have a minimum collections level of $800,000 a year. Over $1 Million is even better. We’ve found, while not an iron-clad rule, practices collecting above that level tend to have good systems, solid staff, good locations, and all the foundational pieces you want as a business owner. On top of being well run, the projected cash flow numbers in practices that size tend to provide enough income to cover the practice loans, student loans and the desired lifestyle of newer dentists. Could you find a turnaround practice that has been mismanaged for years, buy it at a cheap price and turn it around? Possibly, but unlikely. More likely, the cheap practice you’re looking at is struggling for a reason, and the reason isn’t that the owner isn’t as smart as you. (By the way, if you’re worried banks won’t lend to you, read this post about common objections to buying a practice.)
Key Number #2 – Profit – Deciding on whether or not to buy, or the right price to pay for a practice doesn’t depend on collections alone. You should also consider the overall profitability of the practice. The profit margin of the dental practice you’re considering should be at least 40%. A 40% profit margin (or 60% overhead) is close to the average profitability of dental practices in the US. If the practice you’re looking at is below that number, it could be a sign the practice isn’t as well run as it should be. The staff might be overpaid. The systems to order supplies and work with labs might need a lot of work. The rent and other location-based expenses might be so high, you’ll never make the kind of profit you might elsewhere.
Be careful here, though. The right profitability number is hard to know without some help.
How you calculate the profit number is more difficult than just looking at the “net income” number on the seller’s profit and loss statement. In order to see the true profitability of a practice, you need to remove any “doctor-specific” expenses from the business. That includes the selling doctor’s salary and associated payroll taxes. You need to back out any doctor perks, like meals and auto expenses, and interest, depreciation and amortization numbers. A good dental CPA with a strong buyer-advocacy program can help here.
Bottom line – if profitability is strong and at least 40%, you probably are looking at a solid practice.
Key Number #3 – Employee Expense Ratio – The largest expense in most dental practices are the employees. A well-run dental practice will typically have employee expenses range from 24-28% of collections. That includes salary, payroll taxes, and any employee benefits. You would think paying employees more would be better, right? Happier employees equal better employees and thus happier patients, right? Not quite. Remember we’re talking about the ratio of employee pay to collections. The more you grow the practice, the more you can pay your employees, but still a reasonable percentage of overall collections.
Recently, I helped a buyer analyze a business for sale in the Northeast US. The seller collected almost $1 Million a year, 38% of which was going towards employee expenses. I asked him about his approach. He stated “I just want my employees to be happy.” They should have been. Each had an average of four vacation weeks a year, full 401k matching and profit share, and employer-paid health insurance. They were some of the best-paid dental employees on the planet. I wasn’t shocked to see the practice was run about as well as the average practice I look at with buyers. Employees paid well over average didn’t translate into an above-average practice. Furthermore, I learned many of these benefits had been added in the last ten years of the seller’s tenure. The seller admitted they were overpaid, but didn’t want to deal with the hassle of unhappy staff or turnover if he turned off the spigot to the gravy train. Instead he was hoping to pass the buck to the buyer of his practice. The buyer passed on the deal.
Key Number #4 – Lab Fees & Dental Supplies Ratio – Look for a practice that has a combined ratio of total lab fees and dental supplies expense in the range of 10-14%. Of course, this number will differ slightly based on the type of practice. Orthodontists will spend more on supplies, and pediatric dentists less on lab fees. But generally speaking, we find practices spending about 10-14% of their collections income on these two categories are careful about how they spend their money. This is the real secret of this number: while most large expenses like rent and employee expenses in a dental practice are relatively fixed (at least in the short term), lab fees and dental supplies are totally variable. They can be different every month and can be managed accordingly. If you see a practice with a low lab fee and dental supply ratio, chances are the owner of this practice is also managing other aspects of the business well.
Key Number #5 – Rent – There is no specific number to help use as a benchmark with rent. Real estate prices and costs are too local to be very specific here. However, there is a general principle to keep in mind: rent is a fixed cost not easily changed. If the rent number is high, changing that number downward is nearly impossible. Make sure the location you’re considering actually matters to the patients who come to the office, and avoid the Taj Mahal location built solely to help the selling doctor feel important.
Key Number #6 – Hours of Operation – This information isn’t on the Profit and Loss statement, but is vital to know. Assuming the practice you’re looking at is open Mon-Thu, 8:00am-5:00pm could lead you to make mistakes in your analysis. In comparing two practices with similar collections and expense numbers, choosing the office with fewer open hours provides more opportunity for growth, or simply a better quality of life.
Key Number #7 – Will the Cash Flow Support My Goals? – So, I cheated a little to have this one in here, because this is more of an analysis and not one specific number. If the numbers of the practice you’re considering purchasing work to this point, you’ll want to enlist some help to project the cash flow from the business given your personal expenses. Of course, you’ll add in your monthly student loan payments (if applicable) and how much you spend a month at home. Don’t forget to include disability and life insurance payments, as well as savings and debt pay down goals you’ve set for yourself. When meeting with clients looking to buy a practice, I always show them the monthly and annual income they can have, assuming a 7-year practice loan payoff, as well as Roth IRA and 401k savings, in addition to potential changes they want to make with the practice. If the cash flow projections work, we always feel more comfortable moving forward with an offer on a good practice. A good dental CPA like Practice Financial Group can help here.
To recap, to maximize your chances of purchasing a successful dental practice, make sure the practice you’re considering purchasing meets the following basic criteria:
- Collections above $800,000
- Profit Margins around 40% after backing out doctor-specific expenses
- Employee expense ratio in the 24-28% range
- Lab fees and dental supplies ratio in the 10-14% range (with some differences for different specialties)
- Rent isn’t unreasonable, and you’re not inheriting another doctor’s Taj Mahal
- Hours of operation fit the lifestyle or growth goals you’ve set for yourself
- Cash flow projections allow enough money for savings, debt pay down and your lifestyle
I can’t emphasize enough the value of professional help in dealing with this decision. A good dental CPA who specializes in practice transitions will know all of the above and more. What’s more, they will correctly help you in identifying and providing commentary on all of the above categories for any practice you’re considering. Just like an x-ray can almost talk to you as a dentist, a review of a practice’s P&L and tax return are just like having the numbers sit up and tell us a story. The story they tell can mean a good practice and smooth transition, or a bad practice and lots of heartache down the road. As you look at these numbers, remember this post covers only the quantitative aspects of deciding whether or not a practice is worth looking into. There are plenty of qualitative aspects we’ll cover in another post. Good luck!