By: Chris Bentson, President of Bentson Clark
Last quarter we examined five significant, intangible valuation drivers and discussed how they can affect the value of a practice. Intangible drivers are incredibly important in determining value, which is why key operating statistics and ratios should not be overlooked. In any thorough practice valuation, a summary of the practice’s various key operating statistics is included, along with data trends over a period of three or more years. Let’s analyze four specific areas that deserve particular attention and how they can affect practice value.
1. Charges vs. Collections. This ratio measures the level of future business being booked versus what is being collected. The ultimate goal for a thriving practice is to have this ratio at 100% or higher. When this ratio is in excess of 100% (i.e. charges exceed cash collections), it indicates a healthy, growing practice. If the ratio of charges to collections is below 100%, care should be taken to understand why. Most commonly, this ratio will dip below 100% because the practice is starting fewer new patients than in previous years. If the practice has implemented an aggressive policy of collecting payment for the entire contract at the beginning of treatment, the ratio of charges to collections may also be below 100%, although the practice is still growing with respect to number of new patient starts. Practices that are growing at accelerated rates will typically show a ratio well above 100%. When reviewing your practice, if there have been no significant changes in contract fees (other than annual fee increases) or the way contract fees are collected, you want to manage the ratio of charges to collections at greater than 100%.
2. Overhead Rate. The overhead rate is the total adjusted operating costs (excluding doctor compensation and perquisites) as a percentage of net collections. In most areas of the country, the goal for total adjusted operating practice expenses should equal 50-53% of net collections. This ratio will slide toward the upper end of this range or above in practices where occupancy and staff expenses trend higher than national averages. When calculating a practice’s overhead rate, analyzing the previous three (possibly five) years is common procedure. It is necessary to examine adjustments made to the income statements for each year analyzed, which will reveal any non-operating expenses the practitioner is expensing through the practice. If the practice’s adjusted overhead rate for the periods analyzed is above 53%, this often suggests the Practice should consider methods to lower its operating expenses. Since the value of an orthodontic practice is primarily based on the income or cash flow available to the owner, the elevated overhead rate has a negative effect on the Practice’s value.
3. Contracts Receivable Levels. This statistic compares the level of unearned monies (i.e. contracts receivable) to annual net collections. A practice should strive to maintain the proper ratio of contracts receivable to collections. In healthy practices, the contracts receivable balance should typically range between 45-65% of annual net collections. A low ratio (contracts receivable less than 45% of one year’s collections) may indicate the practice is allowing too many patients to prepay its contracts, which could result in inconsistent cash flows in slower months, as the doctor must depend on new starts for cash flow. A high ratio (excess of 65%) could create a high administrative workload and delinquency rates. As an example, a practice with a ratio of contracts receivable to annual collections of 30% would suggest that a higher than average number of patients are paying their contract balances in full at the start of treatment, that the down payment is higher than average, or a combination of both. While accepting a significant number of prepaid patient accounts is beneficial to the owner because he receives the money in advance, a lower level of contracts receivable creates additional risk to a potential buyer, as it could create shortages in cash flows in slower months and leaves a higher than average number of patients for which he or she must provide treatment without receiving monthly fees.
4. Past Due Accounts Receivable Levels. This ratio analyzes the level of earned monies (accounts receivable or “A/R”) that are currently delinquent 60 days or greater. The targeted goal of A/R greater than 60 days past due is 2% or less of annual net collections. If the practice’s past due A/R balance is below the recommended ratio, this demonstrates the practice has implemented strong financial controls and is collecting fees due in a timely and efficient manner. Conversely, a practice with A/R greater than 60 days past due in excess of 2% of annual net collections could indicate the practice should evaluate its collection and patient communication policies. Good credit management and patient communication regarding delinquency policies are generally hallmarks of an efficiently run practice.
The value of a practice is based on many factors, both tangible and intangible. In most practices, a little time and effort from you and your staff can increase the total value. Optimizing practice operations to fall within the goals stated above for each of the noted operating areas will generally increase the value of your practice.
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