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By Max Reiboldt
03/31/08
"We're going to look at an overview of financial statements, drill down to the types of financing that are available, and explain what lenders are really looking for," says Max Reiboldt, CPA, Managing Partner and Chief Executive Officer, The Coker Group. "We
work with many groups around the country, both hospitals as well as specialist
physicians, who have acquired imaging equipment or are looking to do so.
Almost without exception it's a significant capital investment. In fact,
most medical practices, if you look at the physician side only, are not that
capital intensive until or unless they get involved with imaging. Then it
becomes more capital intensive and, obviously, there's a need to have strong
financial statements."
Overview of Financial Statements
"There are three primary sources within standard financial statements for solidifying your ability to use your financial performance as leverage to acquire financing for future growth and expansion of your imaging," Reiboldt says.
"The balance sheet in most settings within a medical practice, and even an imaging center, is really not all that impressive. In many instances, the practice or center uses a cash basis of accounting rather than an accrual-basis, meaning that you are not showing accounts receivable on the formal financial statements. The balance sheet shows a point in time, includes assets, liabilities, and equity, and indicates overall financial strength. However, it's a very weak statement when you are providing it as a source for financing. The profit and loss (P&L) statement is similar as it shows revenues and expenses over a period of time and indicates profitability. If you're distributing 100 percent of the earnings to the owners, then there's really very little left over to provide any comfort to a lender (i.e., retained earnings). Finally, there's the statement of cash flow, which demonstrates over a period of time a P&L statement adjusted for non-cash items and indicates the ability to generate positive cash flow from operations. And, as you've heard, cash is king; if you don't have the liquidity to service debt, the lender will not be happy," he explains.
The following is a simplified example of a balance sheet.
"Don't look at the numbers in this example in terms of their size but in terms of their relationship with one another because that's what a lender is going to look at. The balance sheet shows the amount of cash on hand plus fixed assets compared to the rest of your non-current fixed assets--i.e., equipment. Keeping a significant amount of cash on hand is good since it's obvious that not all the cash is being distributed to the owners/physicians. You definitely want to have a strong amount of liquidity as illustrated. Of course, a potential lender is not only going to look at one month's financial statement. They will want to look at several months and historically review anywhere from one to three years to check for developing trends. Keep in mind that there's nothing wrong with debt as long as it's managed and serviced. The lender wants to know how much liquidity is available within the business to service the debt. And the lender is also likely to give you additional money if you have the assets and the personal net worth to back up the debt."
According to Reiboldt, one unusual item on this balance sheet is retained earnings, which means that some of the net income that's left in the business in being retained and it converts to equity. "This is a strategy that you would want to take. We work with a fair number of standalone imaging centers, some of which are owned by doctors, others by joint ventures between doctors and hospitals, and some by private investors or a combination. The combination doesn't matter as much as deciding how to approach retained earnings and the subsequent tax implications if you're an S-Corporation or an LLC," he says.
An S-Corporation and LLC are taxed like a partnership, which means that the tax is passed to the owners and not paid directly by the corporate entity. Any income left from the business that is not distributed is taxable on the owners' personal income tax returns. The best strategy is to distribute enough earnings, perhaps 40 percent of the amount, so the owners can pay the tax.
A C-Corporation, on the other hand, is a taxable entity. How can C-Corps that are medical-oriented businesses avert paying taxes? "They can distribute all the earnings in the form of compensation, which means they have no earnings or retained earnings," Reiboldt explains. "However, the IRS might say that it really wasn't compensation, but rather a distribution of earnings or dividends that creates taxable income to the corporation. The IRS has indeed done that, so in my estimation the rule would be to not set up a C-Corporation. I would advise setting up an LLC instead, which provides the most flexibility. You can even have different classes of stock and different ownership interests. In addition, you can also have income earning rights, which aren't true equity but a ‘share' of the profits."
While not all debt is bad, Reiboldt notes that it's particularly advantageous to have earnings and retained earnings in an imaging business because there are a lot of assets/capital expenditures. "For example, if you keep all your assets on the books and you have no debt against them (i.e., they are fully paid for) the differential gives you borrowing capacity. As a result, you may not to have to leave as much earnings in the business if this were the case. It's really a very simple process and the key is to remember this formula: assets equal liabilities plus equity. You can simply maneuver the numbers around if you want more debt and less equity--however, that might make it a little tougher to borrow money."
For an income statement, the following is a simplistic example using one key component--the profit and loss (P&L) statement.
"You have personnel costs, which are generally non-provider costs, occupancy, variable expenses, fixed expenses, overhead, and depreciation on equipment. What you come down to is earnings before provider expenses. In this case, the physicians were paid as provider expenses (i.e., compensation), which left a net income of zero. However, having zero net income means that nothing is being put back into the business. When a lender considers financing a medical-oriented business (i.e., a freestanding imaging center, radiology group, or small business with multiple locations), they want to see what is leverageable in terms of assets to strengthen the financials. In addition, lenders are looking at the owners' (physicians') net worth and personal financial credit rating."
Understanding Ratios
Ratios are, in essence, what lenders are looking at. By definition, ratios are applied to data within financial statements to evaluate the organization and answer questions, such as:
• Is the organization already too leveraged--i.e., are there too many liabilities in relation to assets? "The balance sheet that we used as an example demonstrated a lot of liquidity (i.e., cash). The debt was not excessive and there was a fair amount of retained earnings, which equates to liquidity," he explains.
• Can the organization meet its existing obligations in addition to any new financing obligations--i.e., will debt payments be made? "Put simply, you will not be able to acquire new debt if you can't service your current debt. Obviously lenders are not only looking retroactively at the debt that you already have, but also whether you have the financials to support new debt going forward."
• Will the organization continue as a going concern well into the future--i.e., is day-to-day cash flow an issue? "What this means, quite frankly, is that you need to not only service the debt, but to also make money."
"The great thing about ratios is that they are very simple," Reiboldt says. "The first set of ratios fall under liquidity/solvency. The current ratio, which in essence is found in a balance sheet, is current assets (cash) versus current liabilities, which are primarily accounts payable and accrued liabilities plus the current portion of long-term debt. The current ratio demonstrates liquidity. Next, there's the current liabilities to net worth ratio, which is current liabilities versus owner equity. This demonstrates what your debt to retained earnings is and determines whether you're leaving any money in the business."
The next set of ratios fall under debt management. "The first is total debt versus total assets. Again, this demonstrates what assets are potentially leverageable. In addition, you need to know the value of the assets. For instance, are they over-valued? You can certainly depreciate an asset slower than you might otherwise should. As an example, I was working with a large cardiology group that decided to buy a CTA (computed tomography angiography). They consummated a lease on the technology and the leasing company provided a one-year grace period with no payments or maintenance fees. While things went well the first year, they didn't consider that the Deficit Reduction Act (DRA) was going to kick in and that their reimbursements would go down significantly. One year after the group consummated its lease, their financial responsibility on the imaging equipment was $88,000 a month. However, they were bringing in at a maximum something in the neighborhood of $20,000 to $30,000 a month in revenue. To remedy the situation, we suggested that they have a hospital acquire the equipment. As required by law, the hospital was only able to offer fair market value for the CTA. Because the lease was backloaded, the payoff on the equipment was about $700,000 more than the fair market value. In the end, the practice was hung out to dry after only one year because the payoff on the lease was greater than the fair market value of the CTA. I assume that the leasing company felt that the practice could service the debt and they could--if it came out of personal compensation. The lesson is that ratios are extremely important to look at and to ascertain as you work through these processes," Reiboldt illustrates.
The two other ratios under this category are total liabilities versus net worth and interest coverage, which is earnings before tax and interest (EBIT) versus interest exposure.
Finally, the last set of ratios look at profitability. The first is profit margin, which is your percentage of net income versus net revenue. The second is return on assets, which is net income versus average total assets.
"To conclude the discussion on financials, it's recommended that you plan to ensure a strong financial statements that will provide lower interest rates and more funding. Preparation of financial statements by an independent accountant can also lend credence to the accuracy of the data. In fact, many of the higher-ticketed and larger imaging businesses are now required to have an audit to ensure that their financials are in accordance with Generally Accepted Accounting Principles (GAAP). Finally, lenders will rely heavily on the ratio analysis, as well as other factors (such as physicians' personal financial statements), when making decisions."
Types of Financing
"Your financing is going to be largely attributable to the strength of the financial statements, which is why you want to make them as strong as possible and then determine how far you can actually proceed with your strategy for the types of financing," Reiboldt says.
We do not recommend purchasing equipment outright without any financing. "Even used equipment may have a hefty price tag and you also need to account for installation and possible renovations. If you can borrow the money and service the debt at a reasonable rate, then it's advisable to invest your assets elsewhere--whether they are in the pockets of the owners, distributed, or left in the business. It doesn't make sense to borrow with these types of assets."
The first type of financing is asset-based lending where tangibles, such as an MRI or CT, are used as leverage. "You can also leverage accounts receivable--albeit you need to be careful because of current reductions in reimbursements and payments. In short, asset-based lending will allow the organization to use the future value of those assets as security. The maturity can be both short- or medium-term in debt--but the longer you can extend it the better. Keep in mind that longer-term financing is a double-edged sword. If you extend the debt for too long, the asset might outlive it's usefulness and you'll have to replace it. Radiology is a dynamic industry and technology is constantly changing and the value of equipment can decrease rapidly," he elaborates.
There are different types of asset-based financing. First, you can use factoring, which is borrowing against future revenue (i.e., your receivables are your assets). In this arrangement, the lender gives the cash upfront and collects accounts receivable over time based on the value of that revenue. The term is typically a year or less and the rates can be relatively high, in the mid-teens to low 20s. The second type is credit card factoring. This is similar to accounts receivable factoring, but the borrowing is secured through future credit card purchases where the lender might receive 5 percent of all future receipts. The rates are similar to those for accounts receivable factoring.
The third and most probable type of asset-based financing is leasing in the form of either a capital lease or an operating lease. The term can be up to five years and the rate is usually in the mid to high teens. "A capital lease is really another form of debt where the asset is carried on the balance sheet. An operating lease is similar to paying rent on an apartment. It's a period cost that that you expense as you go. Typically, there's not any real residual value in the operating lease. Theoretically, however, there could be residual value in a capital lease. Generally speaking, the rates on leases are higher than if you were to borrow money from a bank or other traditional lending institution. While the leasing company will effectively charge you more now, it won't eat up your line of credit or financing sources for other areas of your business. The leasing scenario is a good option and the funding is usually available through the manufacturer or a referring leasing company."
Reiboldt does point out that there are implications in asset-based lending. In the case of accounts receivable and credit card factoring, it can impede cash flow, interest is imputed and may not be tax-deductible, and it does not "lever up" the balance sheet with more debt. In addition, it can be difficult to get out of a lease. Leases are typically set for a specific term, although some leases may allow an early pay off. Also, you can't borrow against leased equipment and, depending on whether it's a capital or operating lease, it may not show up on your balance sheet.
The second category is debt-based financing. "This is a more traditional approach where you secure a loan from a bank or other lender and you have explicit interest and principal payments. You can, of course, pay off the principal or defer it so you'll be paying interest-only for a period of time. Generally, the loan is secured with some type of asset or personal guarantee. If you do give a personal guarantee, I'd suggest you negotiate that it be lifted after a year or two. Most of these loans also have covenants, which basically say that you have to hit certain ratios on your financial statements in order for the loan to remain valid. For example, if you have loan covenants with a bank that says you have a current ratio of 2 to 1, but the ratio on your balance sheet is 1 ½ to 1, you have technically defaulted on the loan. The bank may renegotiate, but they are likely to ask for more personal guarantees and, as a result, they may lift the covenant but tie up more assets to agree to do so. These loans also have the widest timeframes, flexible payment structures, and often include an origination fee," he explains.
According to Reiboldt, the interest rates for these loans are often derived from the strength of the financials, as well as the personal financials of the owners. "With good financials, you can generally negotiate a rate at prime, perhaps even a little less depending on your relationship with the lender, the loan structure, and how aggressive the lender wants to be. These are all advantages with this type of loan--however, keep in mind the implication of any restrictions and/or covenants."
The third category is a fixed loan, which is usually "event-based" (i.e., building a facility or purchasing equipment) that is provided with some type of securitization (usually secured by the assets that are being borrowed). These loans are typically for a mid to long-term period (i.e., up to 30 years)--however, you can get shorter terms for diagnostic equipment.
The next option is a working capital line of credit. "This is not leverageable and is generally money that is borrowed to meet the day-to-day cash flow needs of a business.
Most of the time, working capital loans are expected to be at zero during certain periods because they are used on a cyclical basis. In short, you only draw the funds when the business needs it. These loans are typically structured where you have to be completely out of this debt for at least a 30- or 60-day period. The rates for these loans can vary since the lender is assuming an element of risk as no leverage is provided. The term is usually three years or less and the rate is often a few points over prime," he explains.
The last debt lending option is a revolving loan that works much like a credit card--it's an ongoing loan that is drawn down and paid off when needed and is usually used for cyclical events. Payment milestones (terms) are negotiated between the lender and borrower and collateral may be involved. The rate can be plus or minus prime.
"The interest and principal are separate in a debt-lending arrangement, with the interest being tax-deductible," Reiboldt notes. "And, needless to say, loans are difficult to get out off and there may be payback restrictions and penalties. Finally, these loans show up on your balance sheet, which may affect the ability of future lending."
The third and final category of financing is equity lending. "This is usually better suited to larger organizations that are looking for investor money. The returns are expensive--most investors in an imaging business are going to be looking for a return on their investment of at least double digits, perhaps as much as 20 to 30 percent. It can provide an option for a smaller business when they need lesser amounts of cash and don't want to go to a bank. However, this will usually require some type of payout from retained earnings. In addition, it will not lever up your balance sheet."
What Are Lenders Looking For?
"They're looking for three little acronyms: earnings before interest, taxes, depreciation, and amortization (EBITDA), free cash flow (FCF), and cash flow from operations (CFO)," Reiboldt points out. Following are the other key things they look for:
• Strong personal financials. "In most cases, imaging businesses owned by private investors and/or physicians are going to require a personal guarantee, at least for awhile."
• Planning and due diligence. "Lenders want to see that you have planned and done your own research and homework."
• Strong leadership. "You need to have the right people to help you figure out whether you really need that additional piece of equipment and whether it will provide the return on investment you need. You can use someone internally, but go outside your organization if you have to," Reiboldt advises.
• A healthy balance sheet. "I can't stress this enough," he adds. "The stronger your balance sheet (i.e., a genuine balance sheet that is not just a bunch of estimates on accounts receivable that you are going to collect), the more apt and capable you will be to finance transactions for major purchases."
• The personal credit rating of each physician. "Almost always, banks are going to want to see the personal financial statements of the physicians, as well as their personal credit ratings. I've had loans turned down by banks because they said the doctors didn't pay their bills personally or had filed bankruptcy at some point in time in their career," Reiboldt concludes.
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