Financial Statement Analysis (Part Two of Three)

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Transcript

Jonathan:

Hey everybody, Jonathan checking in here. And just so you know, this is a second part of the episode. So if you've not listened to the first part yet, you want to go back and listen to it in the prior weeks. We should have it labeled on the episode title what part one is and part two is. So you should be able to see that in the title of the episode it is what episode of episode it is. So thanks.

Jonathan:

Welcome to the Tooth And Coin podcast, where we talk about your adventure of being a dental practice owner. In these episodes we're going to be talking about problems that you will likely face as a practice owner, as well as give an idea about actionable solutions that you can take so that you can get past this problem in your practice. Some of these concepts are really big ones, some of them are very specific, but we hope that these episodes help you along with your journey. Now, a very important piece for you to understand is that this is not paid financial advice. This is not paid tax or legal advice. We are not your financial advisors. We are not your CPAs. This is two CPAs talking about informational and educational content to help you along with your journey. It's a very important piece for you to understand.

Jonathan:

Another thing that you need to know is if you enjoy today's content, join us on the Facebook group. So we've got a Facebook group that is active with dentists that is going to have content talking about what we're talking about today to continue the discussion. Agree with us, don't agree with us, have a story to tell, have something to share? Join us in the Facebook group. If you go to Facebook and you search for Tooth and Coin podcast, click on it to join it, and be able to join us there.

Jonathan:

Finally, if you need some more help, we're developing a list of resources that are going to be centering it around our topics of discussion to be able to help you a little bit more than what the content is doing. So if you'd like access to that whenever it becomes ready, all you have to do is text the word toothandcoin, T-O-O-T-H-A-N-D-C-O-I-N to 33444. Again, that's toothandcoin, all one word, no spaces, to 33444. Reply with your email address, and we'll email you instructions on how to get into the Facebook group. As well as add you to a list to be able to send you those resources when they're available. And if they're available, we'll go ahead and send them to you as well.

Jonathan:

So onto today's episode, hope you enjoy it.

Jonathan:

We work with around 250 offices, and we see there are just differences in dental practices. So a P&L, to me, is a fantastic thing to look at to have an understanding what's happening. But to me, you have to be financially savvy enough to calculate out that seller's discretionary earnings in order to be able to calculate what the actual profitability of this practice is on a dollars and cents perspective. Once that is done, you would then look at those different key categories, which again is another area where I find a lot of dental practices financials don't have things properly segmented inside of their financials. So you can't do that. So the presentation of the P&L for dental practices is just as important as the understanding. Because you and I could look at a financial statement that would come to us, and if it's not a really, really well-defined P&L.

Jonathan:

I mean, we've seen P&Ls that came through that had 10 expenses on it, and that's all the expenses on the P&L. They have nothing else. And it's just like-

Joseph:

Wages.

Jonathan:

Yeah, wages. Like payroll taxes-

Joseph:

Supplies.

Jonathan:

[crosstalk 00:03:36] that. Insurance is on that. They have a consultant, probably, in wages. They probably did some recruitment, that was in wages. And it's just all in one big pile, one big line item. And you can't define anything out of that. So presentation is just as important as well. So what about you? What are some other things you like to look at on the P&L? Because I could probably talk about this for another two hours.

Joseph:

Yeah, no. I like to look at the owner's discretionary expenses and really make sure that you're able to do that. Anytime that you're ever going to buy or sell, it's in everyone's best interest to do what's called normalize the financial statements, which is what Jonathan just described there. Which is like all of this stuff that the owners run through that are ordinary necessary business expenses, if somebody else came and bought the practice out, a PE firm or a bigger company comes out, or DSO, whatever, comes in and buys, they're not going to spend $18,000 on the travel to take you to eight CEs across the country. Right? They're going to come up with probably a more cost-effective way to do that. So I like looking at the owner's discretionary expenses.

Joseph:

I like looking at labor, and seeing how much are we spending on labor? One of the calculations that we make for our clients each month is: what percentage of your money are you spending on clinical staff, hygiene staff, and clerical staff, divided by your top line revenue? And one of the things that we try to get inside the benchmark of the industry. And if they're significantly outside of that benchmark, like in a bad way, if we want that number to be, let's say, 25%, and that number's at 35%, then that tells us that that's something that we need to dig into.

Joseph:

Now, some people might just say immediately, "Oh, that just means we need to cut salaries and cut staff by 25%," but then if we just kind of look at the top line and we're like, "Well, the practice only collected like $20,000 this month," it sounds like it's probably more of a collections problem and a top line revenue problem than a production problem, and maybe an AR problem, versus spending too much in wages. So I like to look at that. I think that when you look at your people, and we've talked a lot about leadership inside this podcast, the people that are inside your practice that are helping you make this thing go certainly are a big, huge asset to you. They officially go on the P&L. But I want to make sure that we can it back and challenge the staff and say, "Hey, look, we need to grow the practice in order to justify the money that we're spending on all of the people that are here." That's something that I look at.

Joseph:

I like to look at supplies and labs and figure out if that's kind of something that's significantly out of whack. If you got $20,000 in collections but you're spending $25,000 a month in labs, anybody could tell you that's a problem. Right? So I look at supplies. Like to look at labs, like to look at wages. And then I'm just kind of looking for like any crazy stuff that sticks out, any kind of big pieces. Like going back to the comparative piece that we were talking about with the balance sheet, I like to look at a P&L and I like to look at this month versus the past three months or four months or five months, so I can see if I can note any trends. And then if all of a sudden I see an $8,000 expense that pops into an expense category, that may be something we need to look at. Like, "What's going on here?"

Joseph:

It's like, "Oh. Well, I had to replace the roof," or, "I had to replace the AC," or, "I had a piece of equipment that I bought," well, maybe that doesn't need to be on the P&L, maybe that needs to be on the balance sheet. Maybe we've got kind of a bigger problem here if we see huge, huge increases. And the technical term that we call it in the accounting world is that we're going to do an analytical review. We're going to analyze, we're going to look at what all has happened. So those are some of the things that I'm looking at when I'm looking at a P&L. I'm looking at wages as a percentage of revenue, like all the money that you're spending. So obviously that's going to include whatever your 401(k) matches, whatever your health insurance is you're paying on behalf, your payroll taxes. All of that goes into paying for your people.

Joseph:

I'm going to divide that by the top line revenue and see what that number looks like. And that's one of the reasons that it's important. You were mentioned in the 10 line income statements we've seen, that's why it's important that wages need to be separated out. It's like, "What do you mean you put your doctor's wages in with your doctor's family and with your hygiene staff, and that means that our wages are now 290 ... Well, of course they're out of whack. Right? Because we need to separate those things out to determine whether or not we're spending our money wisely on our staff."

Jonathan:

Yeah. Completely agree. I was having a conversation with someone on a podcast years ago, and they were like, "Well, taxes are your number one expense as a business owner." And that's a line that has been fed to so many people. I think probably even I heard that in tax class when I was taking a tax one and two in college, or whatever. But in dental practices, that's not the case. Taxes are not your ... Now, if you add up all the different types of taxes, they were talking about income taxes. That's the narrative we're usually give them around that. Your staff is your number one cost.

Jonathan:

It's your number one investment is a way I'd love to be able to rephrase that, and be able to ... the paradigm change of a practice, because if you're spending 25 cents out of every dollar that comes in the practice, up to 35 cents out of every dollar that comes into the practice, on your people, then your practice that nets, let's say, 40%. And if you're paying 40% in taxes on 40% of what's left over, you're only paying 16% in taxes, 16 cents per dollar, for your staff, for your income taxes. Whereas you're paying 25 to 35 cents per dollar for your staff. Big difference, right? So your people are your big difference. And that's a good thing. You want to pay people to do good work for you. I've definitely ran into CPAs or to clients that have had CPAs in the past that have said that, "Oh yeah, you're overpaying your people by this much money. And this is how you're going to get your payroll in line, is you're going to clean house and lower everyone's wages by this amount."

Jonathan:

And it just kind of makes me sick that ... that can wreck the practice if it's not done really, really well. I will say it is possible to have an overpaying problem, to pay people a whole lot more money. But to me, and we use this concept in our firm, I would rather overpay for good people and have my life be easier than have to worry about the $1,500 a year that I'd be saving if I was trying to not be competitive with my wages. This is a pretty bold statement, but I would think that, as a dental practice owner, you should be wanting to be the highest paying person in your area for doing a good job. Because you want the best people. You don't want the worst people. The best people can raise you up really, really high. And so staffing costs definitely look at. But from a percentage-base, from an analytical standpoint, yeah, we got to have some type of understanding of how to reign in these numbers on our staff, to be able to give some type of context on how we're doing, how well we are spending our money.

Jonathan:

And that's what we say we're answering the question of whenever we do an analysis of overhead every month for our clients is, it's literally the question that this information comes in. We have a four questions report, and one of the questions is, "How well did you spend your money?" And we have an overhead analysis that gives you percentages of these things. So definitely staff definitely supplies, definitely labs. But another thing that I really like to look at, after I've looked at profitability and I've looked at the balance sheet and everything like that, is I like to look at growth expenses. What are we reinvesting in? What is going to happen in this practice? And are we seeing growth off of those said expenses? We've got a lot of clients that have 0% of fees or their revenue goes to growth expenses.

Jonathan:

Nothing. They don't spend anything on advertising. They don't spend anything on consultants. They don't spend anything on big new courses or things that they were trying to learn, anything like that, but they're still growing. And then we have people that will spend 15 to 20% of every dollar that comes in on these things, and they're not growing at all. So effectiveness of growth expenses is a very important number that I like to look at just when I'm trying to say ... Because that's a very quick thing for me to be able to tell our clients, like, "Look, your growth expenses are really, really high, and we're not seeing any revenue growth. Is this an effective use of our spent? Of our money? Because I love that you're willing to invest in the growth of your practice, that's what you're supposed to do as a business owner, but is this the most effective use of that money?" And for-

Joseph:

[crosstalk 00:12:11].

Jonathan:

Exactly. So for dentists that can be a really big deal. That's a really, really, really big deal, is effective use of advertising spend, or growth spend, consulting or whatever it may be. And that's something that gets lost a lot whenever you analyze financial statements too much is, what is our ROI? I don't go into such fine detail of saying, "We need to know the cost per lead of everything that happens from every single campaign," or anything like that. I just hope that you've hired someone that's smart to do your advertising that does that for you. And then you can validate those things down the road. I don't think that you should be spending 30 man hours a week trying to figure out just how effective those lead funnels were or anything like that.

Jonathan:

So from the P&L, those are the big things. Obviously we back out interest, appreciation, amortization, and things like that when we do the normalization and seller's discretionary earnings. I don't put a whole lot of weight into looking at interest, depreciation, and amortization. I'm never going to look at an interest ratio or anything like that for a dental practice. I don't think it's really very fruitful of an endeavor. I might very briefly see like, "Oh, there's $30,000 on interest. This person has a lot of debt." But if I looked at the balance sheet I've already noticed that. So if I'm looking at, "Is this a well ... This is a good set of financials," if I see that $30,000 in interest and I see no debt on the balance sheet, then that makes me just roll my eyes and throw the things in the trash, because I know that it's probably not a good financial statement.

Joseph:

Not good financials. Yeah.

Jonathan:

Or interest is [inaudible 00:13:43]. What else have I seen? I've seen credit card fees be put to interest expense. I've seen ... there's just so many things you see get stuck in there. So anyway. Yeah, to me that's what the P&L's for, is show, number one, it has to be well put together just like the balance sheet, just like statement and cashflow, or else it's almost worthless. You're looking at revenue. And then also comparatives. Again, we look at ... Whereas the balance sheet is a snapshot of time, a P&L is a story over a period of time. So whenever you're looking at the stories you have to compare a period over a period to be able to tell that. So in terms of that, of how to use comparatives inside of P&Ls, how do you look at versus the past?

Joseph:

Yeah, so one of the things we were talking about with the balance sheet is getting a chance to look at some different ratios, right? So we talked about like the current ratio, current assets divided by current liabilities, and how we need to basically figure out a way to create a level playing field. So if your practice started out at $400,000 in collections, you add five more practices and now you're at $4 million in collections, right, that's not exactly the same to look at a top line revenue number. So one of the things that we do on income statements is we look at it as a percentage. So we look at what is the percentage of revenue that we're spending on all of these different things. So if we're just going to hop straight down to the bottom line, we take the net income divided by the top line. So if you made $100,000 in net profit, divide that by a million dollars in practice, your net income was 10%.

Joseph:

So as mentioned there, we're going to also make the adjustments that we need for the owner's discretionary expenses, probably going to back out depreciation, amortization, and interest. And we'll be able to get like a pretty clear picture as to how we're doing running a $4 million practice versus a $400,000 practice. Obviously the net income, the bottom line, is going to be different. But if you're making a 2% return on a $4 million practice, maybe you were ahead to not be a $4 million practice, and maybe you would be ahead to stay a $800,000 practice. Right? So we're constantly going to look at the percentages of those things. And as you're looking at those over time, you can compare what's the net income look like, what's the staffing look like as a percentage of income.

Joseph:

You mentioned the growth expenses, Jonathan. So as we grow and as we get established in this market, maybe it doesn't make as much sense to spend as much money on marketing once our, quote, name is out there. Or it may be one of those things we need to slow down the growth in the practice, so we're going to decrease that. So what do all those things look like as a percentage of revenue? So I think those are the things that I'm looking at in terms of kind of looking at things over time. What do those percentages look like, and how are we doing? And what's our net profit dollars look like? Our net percentage look like? And how do we advance it towards the goals that we have in mind, whatever those goals may be?

Jonathan:

Yep. And that's the reason we started the whole conversation with the financial statements is saying that they're a body of work, but they're not the end all be all that a lot of people think. There's probably some dentists that are listening now that think that we're almost being blasphemous by saying that financial statements don't answer every single question that has to do with the dental practice. And to the concepts that you're talking about, yeah, I mean the concept of diminishing returns versus scale is something that happens a lot in service-based businesses. Which diminishing returns, just a quick explanation of that, is as you grow larger, the effectiveness of things or the profitability of things does typically go down, unless you have really big economies of scale.

Jonathan:

There's a lot of people trying to craft a narrative about the DSO space, saying that, "Oh, we've got 20 offices and we get this economy of scale on our supplies. And we're going to make tons of money on that." And when you think about it, okay, let's say that you're going to actually save 10% on your supplies if you have economies of scale. Your supplies are going to be like 7% of your revenue. That means you're going to save 0.7% of your total revenue.

Joseph:

Seven tenths of 1%.

Jonathan:

Yeah. Are you trying to grow to 20 locations so you can save 0.7%? That's not the purpose of that, right? You want to get it so the whole number gets bigger. The other part about that is diminishing returns are a really easy concept for me to be able to ... or a really easy example of that is, when a business grows to a certain size ... The way I tell people to imagine it is, think of it as a capacity, think of it as like a circle. And your total capacity is that circle. And I've also taught people to think of it as like a glass, like that you fill with water. When you get to a certain size you may be overflowing with water, your circle is about to burst. And you've got to expand capacity in some way. And when you expand capacity, there's a very few ways you can do that. You can add time, which means that you open more hours. You can add people, or you can add space.

Jonathan:

And if you already have an effective use of people, but you have access to space, maybe space is the best way to do it. If your people are maxed out in what they're doing in a day, a lot of times what that usually looks like is you adding an associate. And the associate is a really good example of a diminishing return, because in order to have someone there that's a practicing dentist, you can see a dental practice's profitability go from 55% all the way down to like 30% almost overnight when they add an associate in because we're paying this associate so much money to be there comparatively to when they were there before. It's one of the reasons why it's super important to not be adding an associate before you're really ready for it. And there's a lot of different things around what being ready for it means. Like new patient flow, capacity, utilization. There's a lot of different things that go into when that's right for the different dentist.

Jonathan:

And cashflow too. And also, like you said, goals. What is it that you set out to do? And how does this help you address those goals? So the diminishing return concept in that is that there's a point in time where, if you're a full-time dentist that's very busy, say you have 2000 patients, if you've got like 100 new patients a month coming in, you've got 2000 patients already and you're maxed out and you've got two-and-a-half hygienists, and they're maxed out and booked out four weeks in advance, and you've got two assistants that you're already working out of two and a half chairs a day on, and you've got two front office people that are just stressed to the max, maybe the only thing you have left to do is add an associate. And once you do that, immediately after that you're not going to have 4,000 patients. A way that I tell people to conceptualize the capacity of a single dental practice owner, or single dentist, is somewhere between, it depends on the dentist, somewhere between 1500 and 2500 patients. Maybe up to 3000 patients.

Jonathan:

In order for you to have two dentists there, you have to have twice that number of patients. It's just simple, right? It has to be that way. And to get to that, once you've upgraded your glass, the bigger glass, you've got to have more water to fill it. In order to get more water to fill it, you've got to have a patient flow. And if you've got 100 new patients a month coming in, and you've got a new person coming in, it's going to take you, to get to 2000 more patients, at least 20 months to get that full capacity. Now you're also going to have attrition, so that's going to create a little bit more of a flow, a little bit longer time for you to be able to hit that point. But in that timeframe, between the time you add that associate to the end of that time, you're going to have a diminishing return. You're going to have an investment in that new person.

Jonathan:

You're going to be making less money usually. Because usually you have what's called the cannibalization of production, or that's a term that I call it. Because in order to feed that person that came in to work for you, you got to give them some of your production, and they usually don't produce as much as you used to produce. And then you're also paying them 30% of that. So there's a lot of [inaudible 00:21:21] that go into it. But in terms of the growth and scale, whenever we're looking at a P&L, if I look at a practice that has had an associate for only six months, and I looked at that practice a year before, it's going to look very different. So to the determination of the growth and things like that, it's really important you understand your path, what you're trying to accomplish with this practice.

Jonathan:

I talk to dentists every day, one person will be like, "I want to get to a point where I'm doing 1.5 million a year in revenue, no associates, nothing else going on. I work four days a week, and I'm killing it." And I have other people that said, "I want to own, be adding a new practice and a half every year for the next eight years." Everybody has their own path, and everyone's right at the same time. What's right for one person is not right for the other. But the P&Ls will say different things, because the P&L of that guy who's adding an office every year and a half, they're going to have a lot of growing pains. They're going to have a lot of cashflow issues, they're going to have a lot of profitability issues. They're going to have just a lot of issues because the missing component in that is time. And that time usually it leads back to the non quantitative numbers, or nonfinancial numbers, which are more practice management in nature.

Jonathan:

So those are really important pieces. Another thing that we talked about earlier that I wanted to talk about is the breakeven point. So when I'm looking at a P&L, a lot of the data that goes into your breakeven point comes from the P&L. There are things that come from the balance sheet as well, technically. Or the statement and cashflow technically. But the breakeven point is a really, really good number for you to be able to tell, as a business, like, "If I don't really have a whole lot going on, if I break my arm next month, how much is this business going to cost me to keep open?" Or, "What's the minimum amount of money I can produce in a month and actually start making money?" Or, "If I want to make, say, $30,000 a month, how much do I need to be bringing in collections?"

Jonathan:

Your breakeven point is a number that would be involved in each of those answers. I was always [inaudible 00:23:16] the people didn't calculate that internally. And then I have a math background, and so I was like, "I'll just calculate it out and be it." The thing is, it's an evolving number, right? Like it's a number that doesn't stay the same. It has variabilities inside of it. And as you grow it has even more volatility that goes along with that breakeven point. But in general, you can usually come up with a ... Over time it normalizes. Right? So we give that number to our clients every month. "Here's what your breakeven point is," so they can have the context of, "Well, I want to make $30,000. My breakeven point's $45,000. I've got to be producing 75 right now. My average is 55. I got a lot of work to do." They know they got to influence it.

Jonathan:

They're not going to be surprised when they don't have $30,000 at the end of the month. They're going to know what that is. So what about you in terms of breakeven point, things like that? What are some of the things that you like to use a breakeven point in order to be able to use in terms of management and goal setting and things like that?

Jonathan:

Hey everybody, Jonathan checking in here. Just so you know, this is a second part of the episode. So if you've not listened to the first part yet, you want to go back and listen to it in the prior weeks. We should have it labeled on the episode title what part one is and part two is. So you should be able to see that in the title of the episode [inaudible 00:24:33] what episode of episode it is. So thanks.

Jonathan:

That's it for today, guys. I hope you enjoyed this episode of the Tooth And Coin podcast. If you are going to be a practice owner or a new practice owner, and you're interested in CPA services, head on over to toothandcoin.com, where you can check out more about our CPA services. We help out around 250 offices around the country and would love to be able to have the discussion about how we could help your new practice. We do specialize in new practice owners, so people that are about to be an owner of a practice they're acquiring, about to be an owner of a practice they are starting up, or has become an owner in the past five years. That is our specialty. We'd love to be able to talk to you about how we could help you in your services with your tax and accounting services.

Jonathan:

And if you enjoyed today's episode, again, go to the Facebook group, talk to us about what we've talked about, join in on the discussion, and let's create an environment where we can talk about some of these things so that we can all help each other get through these things together so that this adventure of business ownership is more fun, more productive, and better in the long term.

Jonathan:

Lastly, if you want access to those resources that we are currently building, just text the word toothandcoin to 33444. That's tooth and coin, no spaces, T-O-O-T-H-A-N-D-C-O-I-N to 33444. Apply with your email address. We'll send you the instructions in the Facebook group. We'll send you the resources when they're available, and we will see you next week.

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