Practice Value – Part 2
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(Part II: Calculating Earnings)
In a previous article, we explained the relevance of adjusted net cash flow and its calculation. Adjusted net cash flow is the sum left after all operational expenses have been subtracted from the gross revenues. This is what the owner of a practice can spend.
Debt service and compensation for the owner/chief of staff will also be made from this amount. In a small-animal practice, with proper management expenses required for daily operation would fall in the area of 33-37 percent of the gross income. These percentages decrease at various rates in practices with very high or very low gross revenues.
What will be the owner’s compensation for serving as the chief of staff doctor in the practice? In theory, this doctor can be hired by the owner that has no time to attend to the practice. Veterinarians that deal with small animals are usually compensated with 23-25 percent of the income they generate for the practice. This counts as a full package that includes contributions to FICA and benefits. In a regular 2.5 doctor small animal practice, the calculation could be as follows:
Practice gross revenue ———————————————–$1,000,000
Produced by doctors: 85%—————————————– 850,000 ($150K as B & G, OTC, etc)
Total doctor salaries: 25%—————————————– 212,500
Associates’ salaries ($60K + $30K)— ————————-$ 90,000
Associates’ FICA—————————————————— 6,885
Associates’ Insurance package———————————- 5,000
Associates’ CE package ——————————————- 1,500
Associates’ Dues and subscriptions————————— 1,500
Total Associates’ compensation——————————-$ 104,885
Total compensation for owner/COS ($212K – 105K) ——-$ 107,615
The total compensation for associates would be deducted at the start in order to get the adjusted net cash flow. In order to obtain the Gross Earnings of the practice, the owner/COS compensation will be subtracted from the cash flow. Let’s assume that the cash flow is 33 percent, the gross earnings before tax would be 22 percent of the gross, or 222,000 dollars: $1,000,000 gross X .33 cash flow – $108 COS salary = $222,000. This amount represents the gross earnings or returns on investment (RoI) generated by all the tangible and intangible assets of the practice. Tangible assets are inventory, equipment and working capital.
In the intangible category is “goodwill”, a term to coin various all-inclusive elements. Generally, in a well-run practice, RoI would be in the range of 17-20 percent of gross income. In this example, the practice is slightly above average.
By going a step further, we can separate the earnings generated by each type of asset. This way, we will find out the RoI for equipment, working capital and inventory. Excess Earnings will be generated in this example by intangible assets alone (“Goodwill”). In some practices, these earnings are separated for the purpose of practice appraisals, but this is a topic in itself and it will be discussed in another article. In order to determine the Excess Earnings in our hypothetic practice, let’s assume the following:
Gross earnings generated by total assets ————$222,000
Earnings
Equipment ————————— $75K _____12% = $ 9,000 RoI
Inventory ——————————$50K ______5% = $ 6,000 RoI
Working capital——————————$55K ______5% = $ 2,750 RoI
Total earnings generated by tangible assets———– $ 17,750
Balance of earnings generated from goodwill ———— $204,250 (20% rounded)
Note that, in this hypothetical practice, the difference between the percentage of gross earnings (22 percent) and excess earnings (20 percent) is almost very low. This usually happens in small animal practices, where the majority of them will post a difference of 1-2 percent between the two.
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