Why you would need to develop a financial pro forma

In previous months’ Selling Your Practice:  Analyze Your Practice, we discussed important topics such as why so many physicians are selling their practices, the need to continue to run and grow your practice while preparing to do so, to prepare early, and to assemble a team of experts. We also looked at the need to understand the difference between the two most common type of transactions-a capital sale and an asset sale. And, we covered the need to analyze and benchmark your practice. The next step, which we’ll cover herein, is developing a financial pro forma with the help of your expert team, which at a minimum should include a seasoned medical practice appraiser, an experienced tax accountant, and a healthcare transaction lawyer. 

What Is a Financial Pro Forma?

A financial pro forma is a set of financial projections used by the practice to help potential investors or creditors anticipate the financial results of the practice based on a set of assumptions. These assumptions often include material events such as a potential merger or acquisition, a new capital investment or divestiture, a major operating change, or a change in capital structure. 

As a potential seller, developing a financial pro forma for your practice will help a prospective buyer anticipate the financial results of the practice in the event of a sale. Some of the more common assumptions used by sellers when developing their financial pro forma might include: The impact on physician salaries under a new compensation system; The effects of eliminating family members from the practice’s payroll; How eliminating certain “personal” expenditures like travel, meals and entertainment, and automobile expenses will effect the practice’s expenses; The results of adding a new dermatologist or advanced practice provider to the practice; Or the effect of adding new laser procedures to the practice, for instance.

The purpose of the pro forma is to help the seller understand the potential of the practice and how its performance might look in the event of a sale. Your expert team will typically set up the financial pro forma to calculate and report EBITDA.

What Is EBITDA?

EBITDA is the acronym for Earnings Before Interest, Depreciation and Amortization. When a sale is completed, the high-level transaction details are often reported.  One of the most common transaction details reported is the EBITDA multiple.  While there are significant limitations to the use of EBITDA, it has become a popular metric because analysts can easily compare operating performance of similar companies in the same industry.  Furthermore, because EBITDA is a proxy for the cash flow generated by a practice, investors can apply a valuation multiple to the EBITDA to estimate a practice’s value.  While there are a number of ways to calculate a fair market value for a practice, this tends to be one of the most popular approaches because there is a robust market for dermatology practice sales. 

For a simple dermatology practice with no unusual activity, EBITDA is calculated by subtracting all expenses except interest, taxes, depreciation, and amortization from net income.  Often, you can take your income statement and calculate EBITDA by working backward by adding taxes, depreciation, amortization, and interest expenses to net income, then subtracting interest income. 

As a seller, you want to develop a pro forma that puts the best light on your practice, helps to justify a higher expected EBITDA, and drives the value of your practice up. However, you are also obligated to disclose the negative conditions. A sales contract will likely include representations, warranties and indemnities. Representations are your promise of the current state of the practice. Warranties provide a future outlook on the health of the practice after closing, usually twelve months. Indemnities require the seller to make the buyer whole in the event a promise is broken or false promises or representations are made. 

How to Develop a Financial Pro Forma?
Your expert team will help you develop a financial pro forma. They will start by collecting and formatting your last three to five years of financial statements, then make backward-looking adjustments and forward-looking projections based on a set of assumptions. These assumptions are disclosed at the front of the financial pro forma, so the reader can more fully understand its findings. 

You can help your team of experts by considering the assumptions that should be contemplated in your financial pro forma.  Remember, these statements can have a positive or negative effect on the practice. To help with this decision, you can think of your potential assumptions in one of these four broad categories:

• Unusual One-time Events:  Were there any unusual non-recurring events that distorted your typical financial performance? For example, did you incur outside consulting costs to prepare your practice for sale? Was there a fire at your practice? Was there an unusually bad winter which resulted in an uncommon number of office closings? Did a hurricane have a negative impact on your practice? Did you implement an EMR which resulted in lower volumes for 3-4 months? Did COVID-19 negatively impact your practice? Did you get government aide to help you weather COVID-19?

• Structural Changes to the Practice:  Were there recent structural changes to major revenue or expenses categories that are not reflected in the current financial performance? For example, did you successful negotiate a favorable contract with a key insurance payor? Did a major payor make significant policy changes that have had a negative impact on your practice reimbursement? Have you recently added a new highly profitable product line? Negotiated major price concessions from key suppliers? Installed an EHR that helped you improve your coding and revenue realization? Did a junior partner recently receive full partner status resulting in higher compensation? Have there been process improvements that resulted in headcount reductions with your support staff?

• Sales-Related Changes:  After the sale is complete, will there be changes to the practice that may effect its financial performance? For example, will the compensation plan for the practice physicians and advanced practice providers change? Will the practice benefit from the elimination of certain “personal” expenses such as automobile, cell phone, travel costs, and spouse or family salaries that had previously been run through the practice?

• Results From Your Benchmarking Exercise:  Last month, we discussed how to analyze your practice by conducting an in-depth SWOT analysis.  We covered how to use the Five Forces Model to complete an industry analysis, and how to survey your environment to identify opportunities and threats to your practice.  These insights can be invaluable when developing a financial pro forma for a potential buyer. We suggest that you add the most appealing and strategic opportunities that were identified in this exercise to your assumptions and financial pro forma.  Showing a potential buyer that your practice can be even more valuable with the right incremental investments can get a potential buyer even more excited about the prospect of a purchase. 

With an analysis of your practice done and the financial pro forma complete, you and your team are now ready to obtain a practice appraisal-meaning you really need to know what you seek to accomplish by selling your practice.  Next month, we will look at these steps.