A Formula for
the Right Choice
This financial model will make any kind of purchase decision easier.
By Richard Hom O.D.
If you're in a situation where you're wondering if you should buy a practice, the age-old financial tool of return on investment (ROI) modeling can help. ROI can tell you:
- whether you should make the investment
- which of the investment options to take
- the expected financial outcomes of the investments.
For many doctors, an ROI model serves as a divining rod that guides their decisions. For others, it may be a black-and-white decision-making tool. In the end, many other factors will play into the final decision.
This month, I'll construct an ROI model using Microsoft Excel '97 and follow up with a brief discussion on this tool.
The first thing to keep in mind about an ROI model is its validity. For example, the following factors may cause an invalid analysis:
- the investment data are based on cash rather than accrual accounting
- the investment data are faulty or fraudulent
- the model itself is unsound.
The second thing to keep in mind (and this applies for any financial model) is the tool's inability to tell you why you should purchase a practice. The construction of the ROI model therefore depends on your objectives and overall business strategy.
Setting up the model
Begin by opening a new spreadsheet on Microsoft Excel. I usually start at A20 (column A, row 20) and label this cell "Initial Capital Cost." Next, label B20 as Net Income Year 1, C20 as Year 2 and so forth for a span of 5 years (see "ROI Model -- Sample 1" below). Label cell A23 "Cost of capital" and label A25 "Net present value." Format cell A24 for a percentage.
Suppose we have a situation where the sale price of a practice is $575,000 and the expected net incomes for 5 years are $105,000; $115,000; $125,000; $130,000; and $135,000. (The numbers for the expected net can come from the seller.) Enter the purchase price of $575,000 in A22 as a negative number because it's money paid. Next, fill in the net income figures under each year as positive dollar amounts and enter the number 15 in A24. If properly formatted, you'll see the entry 15%. (For commercial valuations, the cost of capital can range from 10% to 30% depending on the source of capital.)
The Net Present Value (NPV) is the key information you'll need at this point to determine whether the investment is worthwhile (the spreadsheet will calculate this). NPV is defined as the worth of a stream of payments (income) from an investment with a consideration for the time value of money. This means that there's an equivalent value to me in today's dollars for this stream of income over the next 5 years. If the NPV minus the initial cost of capital is greater than zero, then the investment is probably good. But if it's less than zero, then you'd have done better to put the initial purchase price into a financial asset netting at least 15%.
Revealing the numbers
Now you're ready to compute the NPV of the stream of income from years 1 through 5. In cell A26 (which is the NPV cell), enter the formula: =NPV(A24,A22:F22). Excel automatically calculates the NPV when you enter this data into cell A26. The result for these numbers is -$150,524 -- meaning you might want to consider socking your money away instead of investing in the business.
I'll adjust the net income numbers (See "ROI Model -- Sample 2") and you'll see that the NPV is greater than zero. This signifies that the investment of $575,000 up front will make a suitable investment. Net income numbers are key to making this model relevant to a doctor's situation.
I left space above the model for other balance sheet items. For example, include end-of-the-year net incomes in cells B1 through B19 for the most recent year's income statement. Likewise, use cells C1 through C19 and so forth to input the income sheet items for the second through the fifth years.
Not the final say
The NPV of an investment is one of many tools in ROI analysis. Other tools include Internal Rate of Return and Accounting Rate of Return. The value of using a spreadsheet model stems from the many "what if" situations you can create with it. Remember not to solely rely on ROI analysis for your purchase decision. You still need to use common sense, market research and business planning to determine the best investment choice.
DR. HOM HAS A RICH BACKGROUND IN E-BUSINESS AND TECHNOLOGY. HE'S NOW A PARTNER AND BUSINESS DEVELOPMENT MANAGER FOR NETWORK APPLIANCE, INC. IN SUNNYVALE, CALIF. AND PRACTICES PART TIME. HE CAN BE REACHED BY E-MAIL AT
Optometric Management, Issue: September 2001