Are you as profitable as you think? (Proceedings)

The Brakke Management and Behavior Study empirically demonstrated the importance to practice owners of understanding the finances of their practices and how few owners really do. Bottom line: The majority of practice owners don't understand financial terms and those that do, make more money. Only half of the group understood "pre-tax profits" and "cash flow." Only 10-20% of the respondents could choose the correct definition of the other terms in a multiple choice format. And it makes a big difference in earnings—Male owners who answered three or more questions right had personal incomes of 7% greater than those who didn't—female owners who answered three or more questions right had incomes that were 19% higher than those who didn't

In addition to the obvious impact on current cash flow, profitability also is a critical determinant of practice value. Historically, practice owners have assumed (and with good reason) that when they decided to sell their practices there would be buyers ready to purchase them and willing to pay a good price. In other words, they have assumed there was value in these businesses that could be transferred to someone else. Of course, there have always been a few practices for which this assumption didn't hold true. A buyer couldn't be found or what buyers wanted to pay wasn't remotely what the seller thought the practice was worth. Typically these practices have been easy to identify and had several traits in common. They tended to be smaller practices with owners who had not focused much on the business side of things. Often the facility and equipment were old and the doctors hadn't kept up with the changes in medicine as much as perhaps they should have. These practices had little profit in them and, because the bulk of practice value is determined by profitability, the practices had little value. Fortunately there weren't too many of these practices.

However, in the last few years, the number of practices with no or little value has been increasing—to the point where the Veterinary Valuation Resource Council of VetPartners (formerly the Association of Veterinary Practice Management Consultants and Advisors) coined the term "No-LoSM practice" to describe these practices. More and more practices, when appraised, did not have the value that would normally have been expected. And, in almost all cases, the owners of these practices were totally unaware of the problem. Some of these practices had traits in common with the practices that have historically had little or no value. They were small practices with a low level of profitability and couldn't keep up with changing client demands regarding service, quality of medicine, advanced technology and improved facilities. The other practices with no or little value, however, were a surprising group. On the surface, these practices would appear to be doing very well. They are located in very attractive facilities, practice good medicine, have all the latest equipment and a large support staff, offer comparatively high compensation and benefits to their employees and, in the owners' eyes, cash flow is strong. However, practice value is largely based on profits and the very factors that make these practices look attractive on the surface are those that are reducing profitability.

Understanding the profitability of a practice is one of the most important concepts necessary to manage a veterinary hospital well. Profitability is the one single number which tells you how you are doing financially. Calculating the true operating profits of a practice is not a simple task. None of the standard financial or management reports a practice usually gets show this figure. Neither the taxable income from the tax return nor the net income from the profit and loss statement represents true profitability. This doesn't mean those reports are improperly prepared; it simply means the reports required by the IRS or accounting standards for small businesses weren't designed to determine profitability. No one report will give a practice all of the financial information it needs to make intelligent operating decisions; unfortunately, the report that seems to be prepared least often is the one that calculates true practice profitability. Because practice owners and managers aren't used to getting this kind of information, they generally don't know what the true profitability of their practice is. The first time many owners realize their true profitability is when their appraiser talks to them about it.

Operating profit is the difference between the operating revenues and expenses of a practice. Operating revenue and expenses include only items normally and necessarily seen in the day to day operations of the practice such as fees for professional services and drugs and medical supplies expense. These items should be stated at fair market value rates. For ease of comparison with other practices, the profit margin is generally stated as a percentage—this is calculated as practice profits divided by gross revenue. Some of the items that must be calculated differently to determine operating profit versus taxable income or net income include: practice owner payments, facility and equipment rent if these items are owned by the practice owner and leased to the practice, services provided by family members to the practice, depreciation, interest on debt and perks.

Owner compensation is one of the most significant adjustments and almost always has to be calculated differently in determining operating profits than would be done for the tax return or other reports. Owners often arbitrarily determine an amount they will be paid through their payroll system; this amount often has no correlation to the actual medical, surgical and management work the owner does in the practice and therefore the tax return or income statement looks as if the practice is more or less profitable than it really is. IRS regulations also dictate how some aspects of owner payments must be handled and these regulations vary by entity type. For example, owner compensation must be reported differently for a C corporation than for a partnership. A practice may appear to be more or less profitable than it really is simply because of these regulations.

So how do you calculate operating profit? Net income per the financial statements or tax return is the starting point. Various adjustments are made from there.

      • Add back: depreciation, amortization and interest on debt

      • Deduct the estimated average amount spent on equipment per year—purchasing equipment is a true operating expense of the practice but depreciation as determined by tax law is not the best estimate

      • Determine how much the owner was paid during the year and what it was comprised of (salary, rent, etc)

      • Adjust owner compensation to represent a fair compensation for medical/surgical work—20% of personal production is a good average in a small animal practice

      • Adjust owner compensation for management work—management expense generally averages 3-4% of gross revenues—if you have a practice or office manager, the owner should get less than 3% of revenues as management compensation

      • Adjust rent expense to fair market value if paid to owner at a rate greater or less than fair market value

      • Adjust equipment lease expense to fair market value if paid to owner at a rate greater or less than fair market value

      • Determine the $ amount of personal perks paid by the practice and remove this expense—perks would be items not necessary to the operation of the practice but paid by the practice generally to gain a tax advantage (examples include excess meals and entertainment, excess auto costs, swimming pool payments, personal furniture, trips to Tahiti, etc)

      • Deduct the cost associated with free services provided to the practice—family members may provide bookkeeping or other services to the practice at no charge—if the practice had to hire someone to do this work, there would be a cost involved and this should be included as an expense

      • Remove any true non-recurring income or expenses such as one-time insurance proceeds or expenses related to a natural disaster

      • Recalculate net income

      • Divide the new net income by gross revenue

The above may sound a little daunting but there are resources available to help you. The National Commission on Veterinary Economic Issues has a tool on its website (www.ncvei.org) to help you calculate your profitability. This tool is a joint project between NCVEI and VetPartners.

The resulting percentage is the true operating profit of the practice—how does it compare to other investments you have? And to other practices? 18% would be considered superior, 13-16% average, and less than 13% is below average.

If your profits aren't what you want them to be, what can you do about it? A lack of profitability either comes from revenues that are too low, expenses that are too high, or a combination of the two. Expense management is often the easiest to understand so it will be discussed first.

What practices don't do when making the decisions to invest in equipment, staff or facilities is to make sure that the costs will lead to increased levels of revenue and thus profits.

For example, how much space and what kind of building is really necessary to practice veterinary medicine? Operating out of the Taj Mahal can be very psychically rewarding but may not be good financially. For example, if a practice moves into a beautiful, new facility and the rent doubles, will there be a sufficient increase in revenue (and more importantly profits) to cover this rent increase?

The same goes for the addition of staff. A doctor's work life may be much easier and personally rewarding with 3 techs trailing behind him or her during the day, but does this doctor actually produce more revenue with this additional support staff? If not, the cost of the staff is eating into the profitability of the practice. Other staff problems seen in practices include the hiring of low-level, minimum wage staff that can't do the job properly, too many part-time employees and a lack of training and supervision. All of these lead to inefficiencies in getting the job done.

Declining revenue or a lack in growth of revenue is the other factor contributing to a lack of profitability. Practices often don't focus specifically on growing revenue because it's harder for them to determine what to do. Prior to the recession, many practices didn't have to worry about it either; they've been fortunate in that the revenue has just seemed to be there. If they don't have the 12-13% growth they did a few years ago, owners often assume that's just because of the recession or the practice has matured or the demographics of their area are changing and that there is nothing they can do about it.

The reality is quite different, however, for many practices. Generally there is much a practice can do to keep revenues strong even if located in a demographically challenged area. For example, are fees appropriate? It's not uncommon to see a practice that hasn't increased fees in two years or has only increased a few of them by a small percentage. Most expenses in a practice rise annually because the providers of those goods and services raise their prices—this is true of staff costs, drugs and medical supplies and the various other goods and services used by a typical practice. If the practice isn't raising its fees at least 5% per year, profitability will suffer even if nothing else changes in the practice.

Lack of attention to discounts and missed charges can also lead to declining revenue. Even a small amount of products or services given away by well-meaning doctors or other team members can significantly decrease revenue and profitability. Missed charges, those not deliberately given away, can also dramatically reduce the profit margin. Capturing charges is generally about having good systems in place and is essential to efficient operations. It is a rare practice who doesn't experience these problems on a fairly regular basis.

Understanding not only the profitability of the practice but the kinds of factors that lead to this state is critical. Until the practice has an idea of the root causes of the problem, it is difficult to determine what the correct solution is. Working with a financial advisor or practice consultant may help in not only gaining a greater understanding of the issues impacting profitability but in identifying and implementing solutions.