Tuesday, January 10th, 2023 | by Christine Elliott
What is EBITDA?
EBITDA – six letters that can make all the difference in your dental practice transition.
Whether you’re thinking of buying or selling a practice or just want to know what your practice is worth, all you need to do is calculate your practice’s EBITDA, and you have the magic key that unlocks all the mysteries of pricing, Right? Well, not exactly. Or at all.
What is EBITDA?
EBITDA is defined as Earnings Before Interest, Taxes, Depreciation, and Amortization. It was initially created to quickly compare the profitability of multiple companies in the same sector. It reflects the operational cash flow of a business by excluding non-operating factors, such as internal expenses and taxes. Because analyzing all the financial details is time-consuming, it was used to streamline the comparative process.
After a while, EBITDA became a standard measurement in the financial industry. We used to call this Profit, but EBITDA does a better job of specifying what is and isn’t part of this statistic. Essentially, that is just what EBITDA is: an organization’s profit.
Before we discuss EBITDA, we need to understand some fundamentals of cash flow to understand just what earnings, or profit, really is. I’m sure many of us think practice profit is the amount left over from the reported income after deducting the practice expenses. This can be the first misleading step in computing profit or EBITDA.
Adjustments to Practice Income
Before we even get to coming up with practice gross revenues, there are required adjustments to the Practice Income that must be made. These adjustments include, but are not limited to, deleting:
Any income from any source other than patient payment for patient treatment provided in the given office
Other Income such as rental for office space, interest, legal and/or insurance settlement payments
Amounts refunded to patients
How to Calculate EBITDA from Gross Profit
Adjust practice expenses accordingly
You cannot use expense data straight from tax returns or profit and loss statements. Practice expenses, just as practice revenues, require adjusting. This is because not all tax deductions are actual expenses and those non-operating expenses must be deleted when computing EBITDA. These items include but are not limited to:
Personal benefits such as insurance, vehicle expense, excessive travel expense, educational expense, and entertainment,
Family salaries that are outside of fair market cost – either higher or lower
Office rental to the practice owner that is outside the fair market value – either higher or lower
Office salaries that are outside of fair market values
Inflated operating expenses that are, in reality, personal benefits to the owner
A commensurate compensation for owner salary for treatment rendered by owner must be included as an expense. For purposes of EBITDA calculations, I impute an owner salary of 35% of the owner’s personal production.
These adjustments are the most critical part of an EBITDA determination and require the most exacting skill, knowledge, and experience—traits not possessed by all who would attempt to calculate EBITDA. Also, if a group of the most expert valuators examine the same practice statistics, they will invariably come up with divergent results in the adjustments to income and expenses, but deviations are usually minimal.
Calculate EBITDA as a percentage of the Practice Gross Income
Once the Income and Expenses are adjusted to precisely and accurately reflect the true operating experience of a practice, we can more confidently determine a reasonable estimation of EBITDA. This is a dollar amount and properly viewed in the most meaningful context. EBITDA should also be examined as a percentage of the Practice Gross Income. There are other possible denominators in order to gain a perspective of a practice’s actual profitability.
Evaluate the Dental Practice Profitability with EBITDA
Congratulations, you’ve officially learned to perform surgery on yourself and can now derive your practice’s EBITDA. Now, what do you do with it? One important use of this figure is to evaluate the profitability of our practice compared to standards of the profession.
Is EBITDA a good measure of profitability?
There is no standard EBITDA percentage, but our firm has decades of empirical data, observation and experience that indicate a typical well-managed practice will have an adjusted owner net income – Salary plus Profit – of 52% of the owner’s personal production. Applying my imputed 35% times the owner’s personal production as owner compensation gives us the salary portion of the practice net income. The remaining 17% of the owner’s personal production is therefore the practice profit, or a dollar approximation.
This is when the fun begins. We can relate to various metrics and come up with various relational percentages. Some of these may be EBITA as a percentage of:
The Owner’s personal production,
The Practice Gross Income,
The Practice Price, or
Today’s Julian Calendar date.
Using EBITDA to Your Advantage
Now the fun really begins. You’re talking to your colleague who tells you “Jim, I sold my practice to BCD – Big Corporate Dentistry – for ten times EBITDA!” Then you tell him that you heard that their mutual colleague, Dr. Jankalewski (not his real name, but not a real person either) got twenty times EBITDA for his practice!” And you both think that you each said something meaningful.
I recently witnessed an interesting negotiation for a practice sale. The buyer and the seller were both basing the practice price on a multiple of EBITDA. They were just decimal places away from agreeing on the multiple of EBITDA to be applied. Being a curious soul, I asked both parties, ‘What figure are you using for EBITDA?’ They replied that they had not agreed upon that figure yet.
If the seller were not aware or chose not to include a commensurate owner compensation as part of the expenses, his EBITDA would be a much larger number than the carefully crafted income as well as expense adjusted and owner compensation inclusive figure that the pros down at BCD would come up with. A crafty buyer could construct a reasonable but low EBITDA figure by using the most liberal adjustments and then offer a higher multiplier which would sound very lucrative to a naïve buyer— but may be actually lower than other offers that were not based on EBITDA.
Evaluating Purchase Offers Using USD
For myself, I evaluate offers in terms of USD, not multiples of EBITDA or even bitcoin. Just give me your best offer in USD and I can compare them perfectly to other USD offers and just forego the EBITDA game that the most skilled players–and this probably does not include you–are bound to win. As Mark Twain used to say, “Figures don’t lie, but liars can figure”.
We’ll want to consider that there are three approaches to practice value and that EBITDA-based results are methodologies of just one of them, the Income Approach. Before we can produce a valid estimate of practice value, we are required to examine the Market Approaches and Asset Approaches to value as well as just the Income Approach, but those are stories for another day.
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