Profitability Vs Cash Flow
This is perhaps one of the least understood aspects of dental practice ownership. I have even had dentists who have been owners for many years fail to understand the difference. For any new practice owner in today’s high risk climate it is important they understand this concept thoroughly before embarking on ownership.
At its core, profitability is defined as the amount of money that remains from your revenue after costs are deducted (in some cases this may be a negative amount). Cash flow is defined as the amount of money going into and out of your business at a given time. It’s application to service businesses such as dentists is somewhat different compared to product based businesses.
Typically, the average product based business will purchase products to on sell. They will purchase these products before being able to sell them. Many suppliers may not offer payment terms to new businesses and payment may be due on purchase of the products. It may take time to on sell these products and receive money to cover the initial purchase. In the meantime, the business has to pay staff, rent, utilities etc. Some of these businesses will have no additional cash or capital reserves and will rely on the products being sold to meet their payment obligations. If the products take too long to sell or do not sell the business will run into cash flow problems. That is, they do not have enough cash to meet their payment obligations. Essentially, it is a timing problem. The business may have been profitable on paper with the goods being sold for much more than they were bought and any associated expenses. However, a slow month with sales lacking can quickly become a large cash flow problem and lead to insolvency.
In a service business such as dentistry this timing problem is less likely. The reason is that our cost of goods (composites, bonds, gloves etc.) are much lower than our sales income. Consumables typically make up 5-10% of the total business turnover. Further, our suppliers usually afford us 30day payment terms, even to start-ups. Moreover, dental practices usually have very little bad debtors and most do not offer in house payment plans to patients. As such, we receive income immediately after a service or procedure is performed. The exception to this may be orthodontic practices and general dental practices with a large amount of orthodontics being done that may not request payment upfront. Although this can be avoided with 3rd party payment plan providers that pay upfront.
Nonetheless, perhaps the most important aspect of cash flow in dentistry relates to servicing debt obligations. That is, when one is purchasing a dental practice and looking at its profit and loss statement they may see a certain profit amount. This profit amount does not take into account debt repayments. A dental practice may be making $100,000 in profit. However, they may have borrowed 1 Million to start the practice and the bank may ask them to repay say $150,000 per year (these are just made up numbers for the purposes of this article). The owner will need to put in $50,000 per year into the business to repay the debt. Hence, even though the business may be profitable the owner will be considered to be in a negative cash flow position. Yes, they will be paying down the debt but they do need to account for this negative cash flow and if they’re willing to put money into the business. Depending on how long the debt is taken over this may go on for many years until it is repaid. This is the reason that many practice owners say the first few years of ownership is the toughest as they are probably not increasing profit substantially and still need to meet their debt obligations. As the profit increases and/or the debt is repaid cash flow becomes much better.
For any associate looking to start-up or purchase a practice it is important to do this cash flow analysis prior to committing to ownership. Your financier will be able to indicate the repayment amounts and combined with the current profitability when purchasing a practice or a predicted profitability for a start-up you will be able to see how much you will need to put into the business from your own personal cash to sustain it.