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Financing is usually the key element of a practice plan.To ensure that credit is obtained, a proposal must be drafted and presented.This plan needs to be in writing, well organized, with reasonable financial data and projections.And these days the borrower needs a good credit score (over 700) and a solid debt-to-income ratio (less than .40 percent).
There are several sources of financing available to a beginning practitioner, whether the loan is for the purchase of a practice, for ophthalmic equipment and instruments, or for a start “cold”.Conventional financing remains the preferred way to obtain the financial resources needed to start up, purchase, or expand a practice.
Full service banks—are the best source for financing the startup of a practice, purchasing a practice, or expanding an existing practice, especially banks that are used for personal purposes (checking and savings accounts, loans for automobiles, home equity loans).
Small Business Administration (SBA)—is a government agency that guarantees repayment of bank loans by small businesses(75% of the amount borrowed, up to $2 million, under the 7(b) loan program). The borrower applies to the SBA, and if accepted gets the SBA guarantee, which can then be taken to an SBA-participating bank to obtain the loan. The SBA makes few direct loans because funds are limited.
Credit unions—are banks that specialize in loans (including real estate), require membership (e.g., navy), and offer competitive terms.Savings institutions—these institutions specialize in real estate financing, including property to be used by small businesses.
Farmers Home Administration—is a federal agency that guarantees loans for non-farming purposes in rural areas (less than 25,000 population favored). It does not make direct loans but rather guarantees repayment (up to 90% of the loan). However, collateral must be available equal to the amount borrowed.
Small business investment companies—are privately owned firms that obtain federal money to loan to small businesses. The repayment periods are often extended (renewable 5 year notes), with a finance charge, and a loan rate 1% to 2% over the prime rate. Often these loans are used for refinancing (monthly payments are less).
Minority enterprise small business investment companies—can provide financing for small businesses in which at least 51% of the company is owned by minorities.Friends and family—are a traditional source of funding, and may also be used as sources of collateral for loans from other lenders.
Loans fall into 3 categories: • Short-term—repayment in a year • Intermediate-term—repayment is made over 2 to 5 years • Long-term—repayment extends for more than 5 years
Short-term loans are used to buy equipment or large inventory, with repayment based on use of the equipment or sale of the inventory. Long- and intermediate-term loans usually require collateral; repayment is made from earnings over the period of the loan. Unsecured loans are typically limited to credit cards.
An important issue is the credit worthiness of the borrower; there are two major questions a creditor will ask: • What is the risk of default on the loan? • What is the borrower’s credit history?
To determine credit worthiness, a creditor will require financial data; for a beginning practitioner, this documentation will include: • A financial statement • Income tax returns (usually 3 years) • A credit report
Credit reports are based on 5 factors: • payment history--timeliness of payments constitutes about 35% of a credit score; • high credit balance—about 30% of a credit score is based on the amount of credit the creditor has access to; • credit card history—about 15% of a credit score is based upon how long credit cards have been held; • applications for credit--about 10% of a credit score is based on the number of times credit is successfully applied for; • type of credit—about 10% of credit scores is based on the type of credit being used: secured loans (e.g., cars and homes) achieve better scores than unsecured loans (e.g., credit cards).
In assessing credit worthiness, creditors consider the “5 C’s”: • Character of the borrower • Capacity to repay • Capital amount that is being requested • Current economic conditions • Collateral used to secure the loan
Collateral (a source of payment if the borrower defaults) is often a key: when a loan cannot be justified by financial statements, a pledge of collateral may enable the borrower to obtain the loan.A pledge of property or a co-signer to the loan is the usual collateral used. Other types of collateral include chattel (property) mortgages, accounts receivable, life insurance policies, stocks and bonds, and savings accounts.
Borrowing requires not only the ability to obtain the loan but also the repayment of principal and interest. Conventional banks use two primary means of repayment: • Renewable short-term notes—the note requires repayment over short-term periods (usually 90 days), with provisions for renewal at the option of the creditor; after the period has expired, the creditor can demand payment in full, but usually repayment is planned over a period of years (e.g., 5 years). • Installment notes—the note requires periodic payment of a stated sum at regular intervals (e.g., monthly) over a term of years (e.g., 3 years); this method is often used for automobile loans.
The preferred type of charge on loans is simple interest: Simple interest—applies a fixed percentage to the amount borrowed for a stated period (e.g., daily, monthly); there is no penalty for early repayment because the interest is prorated (divided into equal amounts). Example: $10,000 is borrowed at 10% simple interest, to be repaid at the end of 1 year; the total repayment will be $11,000 and the interest paid will be $1,000.
Compound interest adds the accumulated interest to the principal: • Thus interest is earned on interest as well as on principal. The frequency with which the interest is compounded determines the cost of the loan. • Example: $10,000 is borrowed at 10% simple interest compounded daily, to be repaid in 1 year; the total repayment will be $11,051 and the interest paid will be $1,051. • Interest can be compounded continuously, daily, weekly, monthly or for other periods. Regardless, the result is a greater interest charge than for simple interest.
Add-on interest can also be charged: Add-on interest—computes the interest charge on the amount borrowed, without proration, and adds it to the principal (unlike simple interest, which is calculated on decreasing principal). Example: $10,000 is borrowed at 10% add-on interest for 3 years; the interest paid is: $10,000 x 10% = $1,000 x 3 = $3,000 total. The monthly payments will be $13,000 ÷ 36 = $361.
Most bank loans for the purchase of an automobile are installment notes charging add-on interest rather than simple interest. There is an early payment penalty on such loans, because the interest is shortrated (paid in unequal installments) rather than prorated.Shortrated interest requires the borrower to pay a fee for administrative expenses and the creditor’s loss of profit. The “rule of 78” may be used to estimate the interest to be paid when a loan is repaid early.
Under the “rule of 78” a 12 month period is summed by adding 12+11+10+9+8+7+6+5+4+3=2+1 = 78, and the interest is designated as a fraction of 78, with the first month being 12/78, the second month 11/78, and so on until the last month, which is 1/78. Thus, in the first month 12/78 of the interest is paid, compared to 1/78 in the last month.Example: If $1,000 in interest is due, how much interest must be paid if the loan is repaid after 4 months?First month is 12/78 x $1,000 = $153.84Second month is 11/78 x $1,000 = $141.02Third month is 10/78 x $1,000 = $128.02Fourth month is 9/78 x $1,000 = $115.38Total interest paid is $538.26 or about 54% of the interest
This same practice may be found in installment notes for 3, 4, and 5 year periods, with interest shortrated so that the percent of interest repaid per year is: • 3 year notes: first year 50%, second year 33%, third year 17% • 4 year notes: first year 43%, second year 29%, third year 18%, fourth year 9% • 5 year notes: first year 36%, second year 28%, third year 18%, fourth year 12%, fifth year 6%
There are 2 types of mortgages: • Real property mortgages require the pledge of the realty as security for a loan; in home mortgages, the creditor provides the money for the home’s purchase, and the borrower repays the loan, with the home as collateral. • Chattel mortgages merely involve personal property (e.g., ophthalmic equipment) rather than real estate.
Mortgage loans are amortized, or paid in equal installments, over the period of the loan.However, the mortgage interest charges are shortrated, so that early payments are mostly interest rather than principal.The interest charges are tax deductible by the borrower, and thus the tax benefits of a mortgage are much greater in the early years than in the later years.
Example: Monthly mortgage payments on a $200,000 mortgage at 6.5% interest during the first year:
A line of credit is often relied upon as financing for a practice: • A line of credit is an agreement by a creditor (usually a bank) to permit a borrower to establish an account from which money may be withdrawn without the need for further approval, as long as it is below the credit ceiling (e.g., $100,000). • There is an interest charge (usually simple interest) which is applied to the amount taken out of the account. If nothing is withdrawn, there is no interest to be paid.
The interest charge may fluctuate (change periodically) depending upon the practices of the creditor (e.g., as the prime rate changes).The creditor is required to make periodic payments to repay the amount borrowed (e.g., monthly), and the size of payments is usually dependent on the amount that has been withdrawn (the more that has been taken out, the higher the repayment).
The borrower can use the line of credit as desired (for personal or business purposes).Although it is possible to obtain a line of credit without collateral, the size of the line of credit tends to be relatively small (e.g., $25,000).Larger lines of credit usually require collateral. For example, equipment and accounts receivable are often used as collateral in business lines of credit.
Lines of credit can also be based upon the equity accumulated in a home. (“Equity” is the difference between the amount that is owed on a mortgage and the anticipated sales price of the home, based on an appraisal.) Such an “equity line of credit” is usually recorded as a “second mortgage” on the home.
Although interest payments made for personal (consumer) purposes are not tax deductible (e.g., credit cards), interest payments on a home equity line of credit are generally deductible. So also is any interest paid to a creditor for a business loan.
Conventional loan provisions include the following: • Favorable interest rate, usually prime rate plus 1% to 2% • line of credit • simple interest • collateral (e.g., equipment) • only interest may have to be repaid in the first year for start-up loans
Typical provisions of a loan agreement include: • interest amount (APR), type and term of repayment • collateral (equipment, receivables) must be pledged • fire and other hazard insurance needed for collateral • security interest in the equipment (creditor has first right to sell the equipment if there is default) • assignment of a decreasing term life insurance policy to the lender (for the amount owed) • restricted right to borrow from other creditors • repayment terms (e.g., monthly payments) • acceleration clause (in the event of non-payment) • binding on heirs (must be repaid from assets of the borrower)
Documentation needed when applying for a loan: • description of location and why it has been chosen • tax returns for the preceding 3 years • detailed estimate of the cost of equipment and furnishings • lease arrangement for an office • estimate of any renovation costs • detailed breakdown of how the loan is to be used • detailed projection of income and expenses for first year • projections of income and expenses for the remaining years • list of all insurance to be purchased and its cost • financial statement To obtain a loan for the startup or purchase of a practice, significant time must be allocated for research and drafting of the proposal.
The effort to construct a proposal typically requires 5 steps: • Valuing the items to be purchased • Ensuring that the list of items is comprehensive • Drafting projections for overhead expenses • Drafting projections for income • Determining the “bottom line” for the proposal
Although the proposal should be crafted to suit the requirements of the creditor, it should typically include the following: • Statement of the purpose of the loan • Description of the practice (type, location, need, competition) • Description of the office lease (including renovations) • Description of insurance coverage • Statement of the financial status of the borrower • Description of the capital needed (loan amount) • Financial summary (detailed by month for the first year and by anticipated income and expenses for the remaining years of the loan repayment period) • Alternative sources of income (if projections are inaccurate) • Summary (which describes the “bottom line” and how long it will take for the practice to get “in the black”)
Creditors are not likely to approve proposals in which it takes more than a year to generate a profit; this should not be forgotten.The key to success is to keep office overhead down, so that the number of patients needed to generate a profit each month is relatively modest. Income projections can in fact be used to determine how many patients must be seen to pay for overhead and provide operating capital.An example loan proposal can be found in Chapter 16 of the textbook.
Business Plan PurposeThe purpose of this proposal is to acquire capitalization to establish an optometric practice in Townsville.
LocationThe location of the practice will be in southeast Townsville on Vision Ease Road. At present the ratio of optometrists to population in the Townsville area is 1:16,000. The preferred ratio for an optometrist in a similar area is 1:5,000 to 1:8,000. Enclosed is a map of the Townsville city school system with the vision care providers marked in. Although there are numerous dentists and pharmacies in the southeast area, there is no vision care provider at present. The closest provider is at least 8 miles away from the proposed site. As the southeast area is an affluent and rapidly growing area of Townsville that will need vision care services, I feel that with adequate capitalization I can provide the vision care needed.
Office LeaseI have negotiated an office lease at the proposed location. The lease is for 5 years with an option to renew for another 5 years. A copy of the lease is enclosed. Insurance CoverageI have been approved to purchase a term life insurance policy in the amount of $40,000 to pay off the loan from the bank should I die before the loan is repaid. In addition, I have acquired an umbrella liability policy to cover malpractice, other types of liability claims, and property loss by fire or other casualty. A list of these policies, the insurers, and the premium costs is enclosed.
Financial StatusA financial statement summarizing my financial status is enclosed. At present, my only significant indebtedness is an educational loan, which totals $28,366, and automobile loans with this bank (in my name and my spouse's name) which total $17,322.I have also enclosed our federal income tax return for the past year. Capitalization NeededI need a loan of $40,000 to establish my practice. Of this amount, $3,700 will be unsecured. The remainder will be used to purchase equipment, for which a purchase money security interest may be obtained by the bank.
