Ten Normalization Adjustments to Look for When Valuing a Small Physician Practice
Many physician practices are small businesses, often owned and run by a single physician who has made every operating decision for years. As healthcare valuation experts, we have seen practices of nearly every size and specialty, and we have found that the financial statements of a small practice often reflect the owner’s preferences and long-standing arrangements as much as the practice’s earning power.
Normalization is the process of adjusting financial statements to reflect what the practice would earn if it paid market rates for everything it needs and nothing more. A buyer, lender, or other party relying on a valuation generally wants to know what the practice can earn under any capable owner, not under one owner’s particular choices.
For a physician considering a sale, these adjustments matter. Many normalizations add earnings back because the owner has been spending in ways a new owner would not. Once those adjustments are made, the practice’s true earning power is often higher than the income statement alone suggests, which can support a higher valuation. Some adjustments run the other way, and a credible valuation accounts for both.
Below are ten normalization adjustments that valuators commonly look for in small physician practices.
1. Vehicles
Physicians often provide a vehicle through the practice, and the type of vehicle typically reflects the owner’s preferences. The relevant question is what a new owner would need to run the business. If the practice requires a vehicle, for example, to travel between clinic locations, a reasonable cost is included, and any amount beyond that is added back to earnings.
2. Outdated Software
Practices sometimes continue paying for systems that are well past their prime. A buyer would generally replace that software rather than keep it, so the valuator removes the legacy cost and substitutes the cost of licensing and supporting a current system. The result is an expense base that reflects what it takes to operate the practice in the future.
3. Related-Party Rent
It is common for a physician to own the building and lease it to the practice. Rent set years ago may no longer reflect the market. Because a new owner would pay a market rate, rent is restated to fair market value. Depending on the current rent, this adjustment can increase or decrease earnings.
4. Supplies
An expense can look unusually high or low for a reason that will not continue. A practice that purchased supplies in bulk, or is drawing down a stockpile, may report a supply expense that does not match its ongoing needs. Supply expense is normalized to a sustainable run rate.
5. Charitable Giving
Many physicians support local causes through their practice. That giving reflects the owner’s personal commitments rather than the cost of operating the practice, and a new owner may choose differently. Discretionary giving is therefore added back to earnings.
6. Staffing Levels
Staffing in a small practice often develops around how one physician prefers to work. Staffing is compared against benchmarks for the specialty and adjusted to reflect what a prudent owner would carry. Before making this adjustment, the valuator considers whether the additional staff is supporting physician productivity. If so, reducing staff would also reduce revenue, and the adjustment should reflect both.
7. Family Members on Staff
Small practices are often family businesses, and relatives may be paid more or less than the market rate for their role. Their compensation is adjusted to what the practice would pay an unrelated employee to perform the same work.
8. The Unpaid Spouse
A physician’s spouse may manage billing or other administrative functions without drawing a salary. That work has real value, and a new owner would have to pay someone to perform it. A market-rate expense is added for those services. This lowers normalized earnings, but it provides a more accurate picture of what the practice earns on its own.
9. Retirement Plans
Retirement plans in small practices are often designed around the owner’s goals. Where contributions exceed what a typical employer would offer, they are normalized to a market-benefit level, and the difference is added back to earnings.
10. Physician Compensation
This is typically the most significant adjustment. A solo physician may take home whatever the practice has left at year-end, which can be well above or below the market value of the physician’s work. The valuator replaces the owner’s pay with fair market compensation for the services performed, based on market benchmarks. This separates the return on the physician’s labor from the return on the business itself.
For a physician preparing to sell, a careful normalization review is worth the effort. It can be the difference between a value that reflects one owner’s choices and one that reflects the practice’s true earning power.
BFMV has the expertise to identify and support the normalization adjustments in your practice’s financial statements. We provide business valuations and fair market value analyses for physician practices of all sizes. Al Waleed Hamze is a business valuation consultant for BFMV. Contact him at alwaleed@buckheadfmv.com to set up a consultation.
