Understanding Income Measurements: Part 1- Net Income

You might be starting to think about the future of your practice and are wondering what your options might be.  There are several options available to owner dentists but first and foremost you need to understand your practice financials to understand the options available to you.  In this three-part blog series, we will be exploring various forms of income measurement.  The first in the series is on Net Income.

Net Income

Net income is on of the most commonly known metrics in financial statements, whether audited or Notice to Reader (NTR). Net Income is intuitive at a high level and measures what is left from revenue, after deducting expenses. However, due to various accounting rules, portions of calculating net income may not be as intuitive when required to dig deeper.

Depreciation & Amortization:

Depreciation is the accounting practice of spreading the cost of a fixed asset over its useful life. Amortization is like depreciation as it also spreads the cost of an asset over its useful life but is used for intangible assets, such as trademarks, brand names etc. There are various methods to calculate depreciation and amortization do so, such as the Simple, Declining Balance or Double Declining Balance methods. The result is:

• The cost of the fixed asset being deducted evenly, over each year (Simple Method). This is mostly used for simplicity and for any asset which does not lose value extremely quickly, but consistently over time.
• A percentage of the total cost of the asset being deducted (Declining Balance). This causes the cost of the asset to be front weighted, with most of the cost being deducted within the first 1-3 years and decreasing amounts being deducted in later years. This is primarily used for assets that lose value quickly after purchase.
• An even larger percentage of the total cost being deducted (Double Declining Balance). This is a more extreme version of the Declining Balance method can be used for assets such as computers or technology and any other asset that loses value very quickly.

Impact on Net Income:

How might this complicate net income? Well, since the depreciation is a calculation, and not the actual cost being incurred in that year, the amount being deducted from your revenue is not an amount that is being paid in cash annually, and you may find that your net income is lower than what you are collecting or would otherwise expect. Alternatively, in the year that you purchase the asset, you would find that there would be a significantly smaller impact on your net income as the cost is spread out into later years, despite potentially having made a significant investment.

As you can imagine, the various methods of calculating depreciation and amortization differ by asset and so the amount that is being deducted fluctuates from year to year and from asset to asset. The exact amount that your net income is being impacted can be difficult to estimate without a background in accounting.

Impairments and Write-downs:

Another common accounting practice which may complicate the calculation and intuitiveness of net income is the accounting practice of recording impairments and write-downs. An impairment, in the accounting sense, is a permanent reduction in value of an asset and is most used for fixed assets. Write-downs are similar in that they are also adjustments in the value of an asset if its fair market value becomes less than it is carrying value. If the entire asset is written down it is treated as a write-off. Write-downs are used for shorter term assets such as inventory but can also be used for long-term fixed assets.

Similar to depreciation and amortization, impairments and write-downs have various tests and accounting rules associated with them to determine if they are necessary. Additionally, the amounts recorded can vary based on the asset so it makes having a clear expectation on how your net income might look, not very straightforward.

Just like in depreciation and amortization, often, there is no money that changes hands when these expenses are recorded and are mostly for recording purposes. As such, you could find that your net income has significantly declined in a year of otherwise great performance, because old equipment was written down or an asset had become impaired.

Dividends:

As an owner, you may opt to take out dividends from time to time rather than, or in conjunction with, taking a personal salary. In such a case, cash is taken out of the business and the cash reduction is recorded on the company’s books. Unlike the other expenses above, a dividend is not recorded as a part of net income, as it is not a business expense, but rather a personal and often tax related choice of a shareholder to extract cash from the business. In such a case, if you are choosing to take dividends rather than salary, you would find that your net income is quite high as it does not include what you are choosing to take out of the business.

For these reasons, net income may not be as indicative of operational performance as other metrics, despite it being of the most common measures of income used in accounting.

Check back soon for for Part 2 of the series: Free Cash Flow.

You can also download our Income Measurement Guide by filling out the form below.  As a bonus, we have included a financial health checklist to get you started!

By: Patrick Kaminski, M&A Associate