What is the Basis of Practice Value? (Part II: Calculating Earnings)

– Doyle Watson, DVM, Simmons Southeast

In another article, we have discussed the calculation of “Adjusted Net Cash Flow.” This is the amount remaining from gross revenues after necessary operating expenses are met. It is the amount available to the owner to spend at the owner’s discretion. The debt service and owner/chief of staff’s (COS) personal compensation are made from this figure. In the well-managed small animal practice, this figure is typically 33-37% of gross, usually less to varying degrees in very high and low grossing practices.

So, how do we determine a reasonable salary to pay the owner for being the chief of staff doctor. Hypothetically this could be a doctor hired by an absentee owner to run the practice. In the veterinary profession, small animal veterinarians are typically compensated at 23-25% of the income they produce. This would be the total compensation package, including FICA contribution and benefits. The calculation could look like this in a typical 2.5 doctor small animal practice:

Practice gross———————————————–$1,000,000
85% doctor-produced—————————————– 850,000 ($150K as B & G, OTC, etc)
25% as total doctor salaries——————————– 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

Owner/COS total compensation ($212K – 105K)—-$ 107,615

The associates’ total compensation would have been expensed in the beginning to arrive at Adjusted Net Cash Flow.

At this point, the reasonable owner/COS compensation is now deducted from cash flow to arrive at Gross Earnings, or return on investment. If the cash flow were say 33%, the pre-tax gross earnings would then be $222,000, or 22% of gross ($1,000,000 gross X .33 cash flow – $108 COS salary = $222,000). This is the gross earnings, or return on investment, created from all the practice’s total assets – tangible (equipment, inventory and working capital) and intangible (“Goodwill” as all-inclusive factors). In the well-managed practice, this figure is typically 17-20% of gross. So, our example is a tad above average in earninings.

A further exercise may be to separate the earnings, or return, created from the tangible and intangible assets. By this process, we determine the earnings individually from equipment, inventory and working capital (tangible assets). The “Excess Earnings” left over then is the earnings created from the intangible goodwill alone. Although not often, in some practices, it may be appropriate to separate these earnings in the practice evaluation process. This topic will be discussed in subsequent articlles

So, to determine the Excess Earnings in our subject practice, let’s say:

Gross earnings generated from all practice assets ————$222,000

Equipment value————————— $75K _____12% = $ 9,000 return on investment
Inventory value——————————– 50K ______5% = $ 6,000 return on investment
Working capital——————————- 55K ______5% = $ 2,750 return on investment

Total earnings generated from tangible assets———– $ 17,750

Balance of earnings generated from goodwill ———— $204,250 (20% rounded)

Notice that in our hypothetical practice, there is almost no difference in the gross earnings percentage (22%) and the excess earnings percentage (20%). This is the case in the great majority of small animal practices, maybe a 1-2% difference in the two earnings percentage.

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