LENDING TO VETERINARY PRACTICES [RMA Journal, The]

In the United States, 71.4 million households, or 62% of the population, own at least one pet, according to a 2009-10 survey released by the American Pet Products Association. Given this high number of owners, as well as the strong bonds they have with their animals, veterinary practices are often thought to be more stable than other types of businesses.

But this may not be the case. The RMA Annual Statement Studies® indicates that industry-wide revenue and profits grew more slowly during the recent economic downturn than in prior years. So it could be that, in periods of economic uncertainty, some pet owners may not view a trip to their veterinarian as a necessity.

This article discusses key factors to consider when lending to a veterinary practice, regardless of the economic environment. These factors include the qualitative characteristics that influence the success of a practice, the quantitative measures that indicate its financial health, and the quality of collateral and guarantees available. If done prudently, lending to a veterinary practice can be an acceptable credit risk.

Analyzing a Veterinary Practice's Qualitative Factors

Although many qualitative factors may influence the success of a veterinary practice, the satisfaction of its clients, the quality of its management, and the effectiveness of its internal control are among the most significant. Other factors, such as the amount of competition and the practice's physical location, may be less important. If pet owners are satisfied with their veterinary practice, they may overlook marketing incentives they receive from other practices, even if those practices are closer or more convenient.

Client satisfaction. Because clients, especially owners of dogs and cats, usually have a very limited knowledge of veterinary medicine, they typically look to their veterinarians to add value that corresponds with the cost. If they feel that a trip to the veterinarian isn't worth it, they may become dissatisfied and look for another practice.

One important way veterinarians and their staff can ensure that clients are satisfied is to communicate effectively about medical problems and remedies. According to Myrna Milani, BS, DVM, "Veterinary communication errors fall into two broad categories: how we talk to clients and what we talk to them about."1 In other words, veterinarians and other veterinary staff should avoid using medical jargon and explain problems and remedies in a way that's meaningful to their clients.

When considering lending to a veterinary practice, it may be difficult to assess the overall satisfaction of its clients. However, it's possible to ask what the practice does to measure satisfaction. Possible methods include having clients complete a comment card after every appointment, sending home health report cards with each patient, keeping track of the number of referrals and complaints from existing clients, monitoring clients' average wait time, and measuring the number of errors clients discover in bills received from the practice.

Quality of management. Because veterinarians and other medical staff often lack the time, experience, or education to manage the practice, it's important to find out which people do the business-oriented tasks and how educated and experienced they are in performing them. As with any business, someone has to hire and schedule staff, enforce employment policies, determine prices, manage inventory, and handle accounts payable.

At a smaller practice, these responsibilities may be delegated to one person. At a larger practice, they may be split between an office manager and a practice manager or hospital administrator. Practice managers and hospital administrators typically have more education and experience than office managers and, if they meet certain requirements, can earn a Certified Veterinary Practice Manager (CVPM) certification from the Veterinary Hospital Managers Association. The effective management of a veterinary practice doesn't have to be limited to its staff, however. The veterinary industry has a good number of consultants who can help a practice in such areas as client satisfaction, pricing, and operations.

Internal control. A significant component in the practice's management is the quality of its internal control. When lending to a veterinary practice, ask who's responsible for logging information into the practice's management system. Employees who work more closely with patients (such as veterinary technicians) are usually the most effective performers in this area. Services should be recorded im22 mediately upon completion while the person responsible for data entry has a fresh memory. Also, it's essential that a veterinary practice obtain "buy-in" from all its employees regarding its fee schedule and discount policy. If a specific veterinarian or technician disagrees with either, they may be more susceptible to charging less (or not charging at all) for a specific service or to a specific client.

An effective internal control system will also reduce the possibility of fraud. Research conducted by Marsha L. Heinke, a consultant to the veterinary industry, found that approximately two-thirds of the veterinary practices she sampled had been victims of fraud, theft, or embezzlement. 2 Although the amount of fraud loss was typically less than $10,000, two veterinary practices in Heinke's sample each experienced a fraud loss of between $500,000 and $1 million.

Common symptoms of fraud include those found in accounting (faulty journal entries, nonexistent or fraudulent source documents, and incorrect ledger balances), internal control systems (lack of segregation of duties, proper authorization, and physical safeguards), and operations (transactions happening at odd times and activities performed by people who do not normally participate in them). About three-quarters of the fraud cases were discovered either through an internal controls audit or from an investigation initiated by a suspicious practice owner.

Analyzing a Veterinary Practice's Financial Statements

Types of financial statements. When financing an existing veterinary practice, obtain at least three years of tax returns and/or CPA-prepared financial statements, as well as interim financial statements for the most recent ending period (Table 1). When financing the acquisition of a veterinary practice, ask for historical financial statements under the seller's ownership and projections under the new ownership. When financing the start-up of a new veterinary practice, obtain projections for at least three years.

Veterinary practices' tax returns and financial statements are usually prepared on a cash basis. Cash basis reporting instead of accrual basis reporting is acceptable, because the majority of a veterinary practice's sales are paid by cash, debit card, or credit card, rather than on trade credit (accounts receivable). Accordingly, a veterinary practice's financial statements should not be significantly different regardless of whether they are prepared on a cash basis or an accrual basis.

Analyzing the balance sheet. Since most sales are paid with cash, credit cards, or debit cards, a veterinary practice's balance sheet should reflect a greater level of cash than receivables. Cash and receivables represent around 19% and 5%, respectively, of a typical veterinary practice's total assets.

Inventory, mainly medical supplies and pharmaceuticals used in medical procedures or sold as end products to clients, accounts for only about 10% of a typical veterinary practice's total assets. However, it's an asset that many practices have difficulty managing. A veterinary practice should keep about one month's supply of drugs and medical supplies per doctor on hand at any time.3 In other words, inventory should "turn" every 30 days. If a veterinary practice's inventory turns more slowly than this, it will likely account for more than 10% of total assets.

If a practice has more invested in inventory, ask why. Common causes of inventory mismanagement include stocking duplicates of similar drugs because of each veterinarian's personal preference, as well as not analyzing the turnover of specific drugs.

Because veterinary practices are capital-intensive, net fixed assets (which are mostly medical equipment) represent about 40% of a typical practice's total assets (Table 2). A quick way you can determine how effectively a practice uses its fixed assets is to divide its sales by net fixed assets. RMA Statement Studies indicates that the median is 15.6X. So if a practice generates sales per net fixed assets that are less than this, find out why. Perhaps it has too much invested in fixed assets for the size of the practice or its employees aren't adequately trained to use the equipment.

Owing to the cash nature of its sales, a veterinary practice generally does not require significant short-term borrowings to finance its operations, although it may finance inventory purchases through trade payables. Besides trade payables, a veterinary practice's balance sheet may reflect other current liabilities, including taxes payable (payroll and sales taxes) and insurance premiums payable (Table 3). When lending to a veterinary practice, be sure to investigate initially, and then periodically, whether it is current on its taxes and all its insurance policies are in effect.

Veterinary practices are often highly leveraged, as their fixed assets are usually financed by long-term financing. RMA Annual Statement Studies indicates that, prior to 2009, a typical practice's total liabilities were around three to five times its net worth, but these have increased significantly because of slowing growth in practices' retained earnings.

Analyzing the Income Statement: Revenue Mix Is Key

A veterinary practice may generate revenue by performing medical-related services (such as exams, diagnostics, surgeries, and noninvasive procedures) and nonmedical services (such as grooming) and by selling retail products (such as pet food and toys) and medications. The graph below shows the mix of various products and services for the U.S. veterinary industry as a whole.4 Currently, medical- related services account for about 70% of the mix, industry-wide.

Sources of revenue. These different revenue sources have different profit margins, and the mix will greatly impact the overall profitability of a veterinary practice. Generally, the more that retail products, medications, and nonmedical services account for a practice's overall revenue, the less profitable it will be. That's because the market for these items is significantly more competitive compared to the market for medical-related services. For example, retail stores such as Target, Petsmart, and Petco sell pet food and pet toys, while online retailers such as 1800PetMeds.com sell medications. On the other hand, examining patients and performing surgeries require advanced training and education, which limits the number of participants who can enter the market.

Because of the competiveness in selling lower-margin retail products, medications, and nonmedical services, veterinary practices usually have to price these items at whatever the market dictates. On the other hand, practices typically have greater flexibility in pricing medical-related services. Given this flexibility, they often set fees that are too low. According to Dr. Gerald Snyder, a veterinary industry consultant, "The number one reason why practices fail to produce sufficient profits is failure to charge appropriate fees-or fees that are high enough to produce a respectable bottom line yet are affordable to the local residents."5

When lending to a veterinary practice, investigate how its various fees compare with other practices in your area. Although data about these other practices may be difficult to obtain, Dr. Snyder believes that an affordable-yet profitable- examination fee can be estimated by multiplying the average family income of the practice's geographic area by 0.0006167. He also believes that an average "transaction charge" per client (what a client pays per visit-that is, the sum of the examination fee and all other fees) should be around 3.5X the examination fee.

These fees are only suggested benchmarks; characteristics of both the veterinary practice and its service area may justify different examination fees or average transaction charges. Accordingly, when lending to a veterinary practice, ask how it determines its various fees and how often it reviews and updates them.

A more objective approach to determining fees, such as consulting a benchmarking publication, should result in a more profitable practice than if the owners just arbitrarily or subjectively decide what to charge. Also, as a rule of thumb, a practice should increase its fees at least 4% to 6% annually to ensure that it remains competitive and that its profitability won't be eroded by any significant cost increases.6

Discounting practices. In addition to setting appropriate fees, a veterinary practice's discounting practices often affect its ability to generate adequate revenue. A frequent occurrence in the veterinary industry, discounting happens when someone at a practice deliberately lowers a fee from that shown on the fee schedule. A veterinary practice may discount fees to attract new clients, provide services for a charity, or perform services for those on a limited income or those needing a significant amount of services, such as multiple pet owners or breeders. Although discounts are not necessarily a bad thing, many practices lose revenue by providing too many of them.

To manage discounts effectively, a veterinary practice must first review its discounts against its mission or goals.7 For example, if it wants to grow its client base by offering free exams to new pet owners, it should review how effective this discount is in accomplishing that goal. If the practice discovers that it is offering too many random discounts that don't tie in with its mission or goals, it should try to minimize them, if not eliminate them outright.

When lending to a veterinary practice, inquire about what discounts it offers, why it offers them, and how often it reviews their effectiveness in helping the practice achieve its intended goals. A veterinary practice should periodically assess the dollar amounts given for each specific discount, as well as discounts overall. According to the American Animal Hospital Association, total discounts accounted for 2.6% of a typical practice's gross revenue in 2007, the most recent year for which data is available.8

Analyzing the Income Statement: Expenses

A veterinary practice's operating expenses can be broken down into four types: variable expenses, facility expenses, fixed expenses, and personnel expenses.

Variable expenses-such as laboratory expenses, drugs, and medical supplies-should be 22% to 24% of revenues.9 The practice's ability to manage its drug and medical supply inventory effectively often influences how much it will incur in variable expenses.

Facility expenses, which include rent and utilities, should be between 5% and 8% of revenues.10 Facility expenses significantly greater than 8% may indicate that the practice's current location is too large or too expensive.

Fixed expenses consist primarily of administrative overhead, such as office supplies and advertising, and should be between 8% and 9% of revenues.11

Personnel expenses include salaries and benefits to veterinarians, technicians, and support staff. These items should represent 45% to 50% of revenues.12 Personnel expenses greater than this might indicate that the practice's employees aren't generating the level of revenue that they should be-which could be addressed through training or by tying veterinarian compensation to his or her production. On the other hand, personnel expenses significantly less than this may indicate that the practice pays low salaries or doesn't offer competitive benefits, which could lead to low morale or high employee turnover. (See Table 4 for data on expenses and profits.)

Analyzing Cash Flow / Debt Service Coverage

If financed by debt, veterinary practices will likely have long-term debt requiring principal amortization rather than a short-term, revolving line of credit. Accordingly, a good way to assess a practice's ability to repay its debt is by looking at its debt service P&I coverage. This ratio is calculated by dividing net cash after operations for the current period by the sum of interest expense, the current portion of long-term debt, and the current portion of capital leases.

A ratio of less than 1:1 indicates a company that must borrow funds to meet some or all of its financing obligations. RMA Annual Statement Studies shows that veterinary practices' debt service P&I coverage has remained fairly consistent during the past six years, despite slower revenue and profit growth in 2009 and 2010 (Table 5).

Collateral and Guarantees

As with any business loan, you should obtain secondary and tertiary repayment sources in the form of collateral and guarantees from the practice's owners. Typically, collateral consists of the practice's medical equipment and the owner-occupied commercial real estate (land and buildings) on which the practice operates.

Before taking medical equipment as collateral, obtain serial numbers and, if possible, perform a third-party appraisal or some other estimate of value. Because medical equipment may be difficult to liquidate, except to another veterinary practice, it's best to use conservative loan-to-value ratios. And because medical equipment has a limited purpose, be sure to investigate its functional obsolescence and any other factors that could impair its liquidation in the event of default.

Veterinarian practices are often located in shopping centers or office parks. Because a practice's interior space can typically be built out for another use, it carries less resale risk than other types of owner-occupied real estate. Nevertheless, perform the normal due diligence you would with any other type of owner-occupied commercial real estate. The quality of guarantees should be evaluated the same way as for any other business loan: Examine personal financial statements, personal credit reports, and at least two to three years of personal income tax returns.

Conclusion

Lending to a veterinary practice can be an acceptable credit risk, provided that you perform initial and ongoing due diligence. Risk can be managed appropriately if the borrower's qualitative factors are found to be similar to those of successful practices and if its financial performance is assessed to be at or above industry norms.

Successful practices tend to satisfy their clients, hire competent people to manage their business affairs, and focus on preventing fraud and theft. Profitable practices tend to derive more of their revenue from providing medical- related services rather than low-margin nonmedical products and services. They also tend to set appropriate fees for their services and manage their discount programs well.

Be sure to keep in mind, though, that a successful and profitable veterinary practice doesn't always ensure that your loan will be repaid. So be sure to evaluate the adequacy of available collateral and guarantees. v

For additional information, consider enrolling in the RMA course Lending to Medical and Dental Practices.

One important way veterinarians and their staff can ensure that clients are satisfied is to communicate effectively about medical problems and remedies.

A veterinary practice's financial statements should not be significantly different regardless of whether they are prepared on a cash basis or an accrual basis.

Successful practices tend to satisfy their clients, hire competent people to manage their business affairs, and focus on preventing fraud and theft.

Notes

1. Myrna Milani, "Meaningful Client Communication," Veterinary Forum, June 2001.

2. Marsha L. Heinke, "MLHCPA's 2011 Survey of Fraud, Theft and Embezzlement in Veterinary Practices," CPA, Inc. Available at www.veterinarypracticefraud.com.

3. Wendy S. Myers, "Effective Inventory Management," Common Solutions for Veterinarians, Inc., 2010.

4. IBISWorld, "Veterinary Services in the U.S.," August 2011.

5. Gerald Snyder, "Don't Be an Unintentional Not-for-Profit Practice," DVM Newsmagazine, February 1, 2011.

6. Dick Goebel, "Drive Revenue through Pricing: AAHA Veterinary Fee Reference," AAHA/VetPartners Economic Bulletin, American Animal Hospital Association, October 2009.

7. Karen E. Felsted, "Leaky Revenue: Capturing Discounts and Missed Charges," AAHA/VetPartners Economic Bulletin, American Animal Hospital Association, August 2009.

8. Ibid.

9. "The No-Lo Practice: Avoiding a Practice Worth Less," VetPartners, 2009.

10. Ibid.

11. Ibid.

12. Ibid.

by Greg Fraker, CRC

Greg Fraker, CRC, is a senior credit analyst with Mutual of Omaha Bank's Community Association Banking division. He has more than 15 years of lending experience as a credit analyst, loan officer, and loan review officer. He can be reached at Greg.Fraker@mutualofomahabank.com.