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Metrics that make you attractive to lenders

Nov. 10, 2022
Whether you ever take out a loan, these five ratios should matter to you because they indicate the long-term sustainability and trajectory of your practice. Here’s what you need to know.

Perhaps you’re a die-hard fan of zero debt, or perhaps you’ve heard that leverage is key to financial growth. No matter which side of the coin you fall on, knowing the health of your practice will serve you well. Many practice owners look no further than the income statement, but why is it that banks largely depend on the balance sheet? In pre-COVID times, it was a struggle to get practice owners to pay attention to what a bank might care about if they weren’t actively searching for a loan. Whether you ever take out a loan or not, these ratios should matter to you because they are indicative of the long-term sustainability and trajectory of your practice. The ratios that can tell the story of your business are Altman Z-score (also called Survival score), current ratio, working capital, debt-to-equity (safety), and AR days.

Calculations and considerations when purchasing patient records

Forgotten factors in ROI

Altman Z-score (survivability)

What does it indicate?

The Altman Z-score is used to predict an organization’s ability to pay its liabilities and avoid bankruptcy in the next two years. It is estimated to be 80%–90% accurate in predicting bankruptcy based on audit reports.1

How do you calculate it? (Figure 1)

Your ability to calculate this score is less important than your understanding of it. Because of this, I would recommend going directly to an online calculator,2 especially if you are not as familiar with the ratios used to calculate the score.

What’s an ideal score?

A score above 5 is considered great and above 3 is good. Between 1.8 and 3.0 is considered a gray area where your ability to repay debts is unclear. Anything below 1.8 is considered a distress zone, where your practice will likely be considered unable to pay its debts from a lending perspective.

What does this mean to you? 

The Altman Z-score has become more nuanced since its introduction in 1968, and the most relevant metric to track is your trends. Are you trending up and improving your other ratios? Banks love to see this. Has your score decreased one year due to capital investments that will improve the overall success of your business? Banks will understand this. Has your score decreased more than two years in a row and entered the gray zone? That might cause your bank to reconsider your creditworthiness.

How can you move this ratio?

Moving this ratio takes a long-term strategy, as the number affects different financial statements. If you are looking for the fastest way to improve your Altman Z-score, increasing your profitability through EBIT will give you the greatest improvement.

Current ratio

What does it indicate?

The current ratio highlights the practice’s ability to pay obligations that are due over the next year.

How do you calculate it?

What’s an ideal score?

A score of 2 is widely considered to be ideal. This is not a ratio where higher or lower is better.

What does this mean to you? 

A low score would indicate that you’re overextended on credit and loans. But an excessively high score would indicate that the practice is not effectively using cash.

How can you move this ratio?

If you find yourself with a high ratio, it may make sense to move cash into other investments. If you are planning for a big cash expense (restructure, new clinic, etc.), you would be wise to create a proforma and cash forecast, as many of these big projects naturally reduce current ratio.

If you find yourself with a low ratio, focus on activities that will increase your cash on hand and reduce your short-term liabilities. This may mean paying off credit cards and advances before buying any new equipment or consolidating short-term loans into one long-term loan.

Working capital

What does it indicate?

Working capital has a similar function to current ratio. It shows how much actual capital you have after your short-term liabilities are paid. This is a great number to track if you don’t lean heavily into short-term credit options.

How do you calculate it?

What’s an ideal score?

This is a number that really depends on the size of your practice, your risk tolerance, and your current ratio. If you have 10 clinics, you will likely want a higher number than someone with just one clinic.

What does this mean to you? 

Generally, the higher your working capital, the higher your creditworthiness. This means that if you are planning for an investment or a big expense that jeopardizes your cash position, apply for a loan while your working capital and financial ratios are strong.

How can you move this ratio?

As with current ratio, there are only two ways to move your working capital ratio: increase your current assets or decrease your current liabilities.

Debt-to-equity (safety)

What does it indicate?

This is the number one ratio that banks will look at. It indicates how leveraged you are—in other words, how much of the value in your business is owned by you and how much is owed to lenders.

How do you calculate it?

What’s an ideal score?

From a creditworthiness perspective, lower is better. Anything under 3 is ideal. Historically, anything over 3 means your bank is likely to request more reports and financial statements.

What does this mean to you? 

With the increase in SBA loans, we are seeing higher ratios than ever. Higher means more leveraged, which is less safe from a lending perspective. But like the other ratios, what’s best for the bank isn’t always what’s best for you. If you have an excessively low score, you might not be maximizing the return on your equity.

How can you move this ratio?

This is a ratio that takes strategic planning to move. The easiest levers to pull are additional paid in capital or reducing shareholder distributions.

AR days

What does it indicate?

AR indicates your ability to turn receivables into cash. Put another way, it’s how quickly you pay the money you are owed from production.

How do you calculate it?

What’s an ideal score?

The lower the score, the better. If you are a fee-for-service clinic, ideal AR days are zero. If you bill insurance, 35 days or fewer is the ideal.

What does this mean to you? 

If AR days in your clinic are high, then it is worth taking a deeper dive into same-day patient payment and first-time insurance claim acceptance. If you are not collecting patient portions on the day service is rendered or you are getting a lot of insurance claims bounced back, then AR days are likely to be high. And worse than hampering your cash flow, resubmitting insurance claims and collecting past-due payments from patients are time-consuming tasks that could almost always have been avoided.

How can you move this ratio?

Luckily, this ratio can turn around very quickly, especially if your clinic is fee-for-service. If you have a significant portion of your AR due from patients, it might be time to consider accepting financing such as CareCredit or reconsider how you communicate options to patients if you already accept financing options. If a significant portion of your AR is due from insurances, it’s time to evaluate your process and figure out why acceptance is so delayed.

Wrap-up

If you manage your practice’s finances by either checking your account balance or looking only at the income statement, you are with the majority of practice owners, but you are missing a big part of the picture! Banks use the ratios discussed in this article because they are an indicator of longer-term solvency and success. Because a good career is a long one and a better career is a short one (early retirement), you should be monitoring these ratios so you can optimize not only your practice production but the long-term return as well (including an exit strategy).  

Editor's note: This article appeared in the November 2022 print edition of Dental Economics magazine. Dentists in North America are eligible for a complimentary print subscription. Sign up here.

References

1. Hallas N. Altman Z-score as an indicator of financial health. Audit Analytics. January 30, 2020. https://blog.auditanalytics.com/altman-z-score-as-an-indicator-of-financial-health/

2. Loo WB. Altman Z-score calculator. Omni Calculator. Updated July 11, 2022. https://www.omnicalculator.com/finance/altman-z-score

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