Cash flow is simply the net sum of qualified revenues and expenses that a dental practice, or, for that matter, any business encounters. The final net sum may be a profit or a loss. Not surprisingly, a profit and loss statement will be a report for generating cash flow results.
It is important to consider that not all income and not all expenses are included in a profit and loss that is generated for the purpose of analyzing a practice’s performance.
When a practice owner or purchaser or lender for purchasing a practice looks at a profit and loss statement, they generally want to know just what the actual expenses and income are. When examining practice income, we should include solely that income from treatment provided to patients. Patient cash, checks, credit cards, insurance payments, or other sources of payment solely related to treatment rendered are included.
Not included in revenues is Other Income, such as commissions earned by the owner while practicing in another practice. Also not included is interest income, investment income, insurance settlement proceeds, lawsuit awards, loan income, rental income, or owner contribution to name a few items.
Not included in expenses are items that are legally treated as deductions, but are not actually a required expense for the practice. Items such as continuing education in excess of $2,500 (otherwise known as a family vacation), travel and entertainment (unless you’re a specialist courting referral sources), amounts paid by the practice for personal accounting or legal expenses (we can always see when there was a divorce), personal insurance, payroll taxes for the owner, personal phone and utility expense, and non-recurring expenses such as a consultant or contract labor, to name a few.
There are other expenses routinely seen in profit and loss that show up on the expense line but are not cash expenses, just paper expenses to reduce the owner’s taxable income. These items are depreciation and amortization, and when they show up on a Profit and Loss, we delete them as expenses. New practice purchasers will be surprised to find that the principal amount of their loan payment was not a deduction, but a similar amount in the form of depreciation is a deduction.
Another expense item that surprises many dentists, when precisely analyzing cash flow, is to impute the salary of the owner as a practice expense. We assign an amount equal to 35% of the owner’s personal production as cost of labor that is imputed to be paid by the practice. This salary amount is deducted as an expense, just as rent or laboratory expense.
When weare satisfied that we have accurately listed the appropriate income and expense items, (including the expense of owner salary), we subtract the expenses from the revenues and determine profit or loss.
The profit therefore, is a good indicator of practice efficiency. In a typical vanilla practice that is managed well, we expect to see a profit in the range of 17% of the gross revenues. This profit is a product of ownership, not of effort. Remember, we paid for the owner’s work effort in the expense item of owner’s salary.
Why is cash flow so important? First of all, it determines your income during the course of your career. The owner of a profitable practice will be able to retire on the same income much sooner than a less profitable practice would afford. More profitable practices generally sell for a higher multiple of revenues and may also sell quicker. Extra profit affords equipping and operating a practice at its highest potential with modern equipment, well paid competent staff, and other benefits that money can buy.
Cash flow is important to practice purchasers because whether they know it or not, the profit is the last bottom line of what they are actually purchasing. More importantly, in the beginning years of practice ownership, the profit is what pays the bank payments, or debt service, for acquiring the practice. If a buyer doesn’t receive sufficient cash flow, they can tend to burn out due to working too hard for too little money, so it is a critical element of professional success.
If larger profits are better, how do we achieve them. There are two ways, and while either one individually will work, a combination will result in the best outcome. The methods are to increase income and decrease expenses. Not surprising, but it does require active hands on management to achieve either.
Decreasing overhead should be accomplished during the ongoing management of a practice. Areas that are controllable and seem to get out of control the easiest are dental supplies and salaries.