The way you structure your practice debt will make a material difference to your cash flow, your retirement and your ability to enjoy life. In this article I am going to provide a framework for determining your ideal debt structure. This material is taken directly from The Financial Leadership Solution™ which is the best way I have found for helping doctors through this process.
Free Cash Flow, Compounding and Practice Debt
Let's begin by defining some terms and concepts.
The single most important financial measure of a business is free cash flow. Free Cash Flow is the money generated by a business that is available for the owner of that business after all expenses and capital expenditures have been made. The more free cash flow available, the happier the owner, assuming all other things are held constant. You want to maximize your free cash flow.
Compounding can be defined as returns on your returns. Pretty simple and really powerful. The trick to wealth is to generate free cash flow and invest it in assets that compound. Your debt structure will drive what you have available to invest.
Practice debt is any borrowed funds used for your practice including equipment leases, credit cards, seller notes and bank or building loans.
Your ideal debt structure is defined as the debt that creates the monthly payment that allows you to generate the free cash flow you require to meet your long-term business and personal goals and allows you the flexibility to make changes to your assets when your goals dictate while maintaining your lifestyle.
Ideal Practice Debt Structure
With these definitions behind us, we can begin to determine how to identify your ideal practice debt structure.
The first step is to define your short and long term goals. Do you want to move your office or residence, re-finance your house, fund your retirement, vacation in Europe, start a college fund, buy a boat. You must know what your ideal future looks like so you can plan accordingly.
For example, you don't want to pledge your home as collateral for a business loan when you plan on moving in 3 years. You will be forced to re-finance your business loan so you can sell your house. Remember, you must maintain the flexibility to make changes to your assets as your goals dictate.
If your goal is to fund your retirement, you probably don't want to obtain a short term loan with large payments just to get a lower interest rate. You have to pay taxes on the principal portion of your loan payments (remember only the interest is tax deductible). This will eat your cash flow, reducing the amount of money you have available for investing.
The learning objective is to map out your goals and make sure your loan does not interfere with you achieving them.
Lifestyle Expenses
The second step is to determine your lifestyle expenses. These are non-business expenses like personal taxes, property taxes, personal debt and household utilities and expenses. Don't forget all of the Latte money. That's the money you spend but can never remember what you spent it on. This is a big category for most families. Add up all of these expenses and call it your Lifestyle Expense. This is the amount of money you need to take out of your practice to maintain (not expand) your current lifestyle. Many lenders will approve you for a loan that you cannot afford. Why? They simply do not make an accurate assessment of your lifestyle requirements.
The learning objective is to understand how much you spend monthly to maintain your lifestyle. Do not use fuzzy math (guesstimates). Research it, and know your lifestyle number.
Practice Cash Flow
The third step is to determine your Practice Cash Flow before your debt payments and lifestyle expenses. This is simple. Print your profit and loss statement for last year (or Year to Date). Take the net income (loss) figure and add back any non-mortgage and non-recurring expenses in addition to any owner distributions. This is your cash flow available for lifestyle and debt service. This is your net before you pay yourself or any lender. Note that your lifestyle expense may be different than what you actually paid yourself.
Now think back to your goals. What were they and do they require some of your practice cash flow to achieve them? For example, let's say you need $100,000 for a down payment on a new house in three years. You will need to add this cash requirement to your lifestyle expense ($100,000/36=$2,778 monthly).
Take your practice cash flow, subtract your lifestyle expenses including any goal requirement funds. The result is the amount of money you have available for practice debt service. This is called Cash Flow Available for Debt Service.
Wiggle Room is financial jargon for having the ability to maneuver financially. You want Wiggle Room in your cash flow. Why? So you don't get physically sick when you have more months left than money available. I recommend that you have 1.25 times your monthly debt payments in cash flow. Put differently, you want $1.25 in cash flow for every $1 in debt payments.
Let's review an example and see how this works. Dr. Big is looking to buy a new office building for $1,000,000 and move his practice into it. He already has $300,000 in building debt, which he will eliminate when he sells his old building. Dr. Big calculates his Cash Flow Available for Debt Service to be $115,341. How much can he afford to borrow?
Wiggle Room Calculation = $115,341/1.25 = $92,273
Maximum Monthly Payment = $92,273/12 = $7,689
How much can Dr. Big actually borrow?
| Term |
25 years |
20 years |
15 years |
| Rate |
7.50% |
7.50% |
7.50% |
| Payment |
$7,689 |
$7,689 |
$7,689 |
| Loan Amount |
$1,040,526 |
$954,452 |
$829,438 |
Longer term debt allows you to borrow more money. Do not be swayed by a banker that only sells 15 year loans. He is going to tell you how much interest you can save using his product. He is not going to care that your cash flow is not as strong or that your tax bill will be higher. He may even lower your interest rate to say 6.50%. But, based on the above example, that only allows you to borrow $882,669. This analysis assumes the building appraises for what it costs to construct.
The learning objective is to know the payment you can make while maintaining your lifestyle and achieving your goals. You should search for a loan after you have calculated your lifestyle and practice cash flow. The loan term will drive how much you can borrow assuming a given payment.
Here is what we have just learned. You want your practice to generate the free cash flow necessary to fund your lifestyle and your business and personal goals. You must start with your goals, then calculate your lifestyle and practice cash flow. This will drive what payment you can afford. Then review how much you need to borrow and pick the loan term that equates to that number. Building loans can have terms up to 30 years while practice loans can have terms up to 15 years. For practice loans, you can expect to pay a higher rate for a longer term.