42: What is EBITDA

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Hello everyone, and welcome to another episode of DSO Secrets. I am Ken Kaufman, your guest host today, filling in for Emmett Scott. In the last episode when I filled in, I talked about this fascination, especially in the finance world, with the concept of ebitda. Today I want to follow up on that by talking about what exactly EBITDA is. And then in a future episode, I will talk about what EBITDA is not and what it should not be used for. So to set the table for today, I want to share with you something that I've done inside of the Community Dental Partners business, our dso. Every other month we have a town hall meeting. All employees are brought together and we talk through where the business is going, what we've done successfully in the past, and celebrate some key victories and other accomplishments within the business. My role is to update everybody on how the company is doing financially relative to budget and relative to prior year and relative to our growth trajectory in order to set the table for that with those employees. I started out the very first time by giving an analogy so that they could understand the difference between what's called gross versus net. Now, I use a turkey leg example, but if you're not a meat fan, then just envision an apple and I'll explain to you how this works. I start by displaying this turkey leg or an apple and I say, this is gross. This is all the money that's coming into your practice. And by the way, I'm using this as a cash basis accounting structure. In the future, we'll probably talk more about accrual, but just this is cash basis only. All that money that comes into your dental practice, that is the turkey leg with the bone in and everything, or the apple, it's, you've got the core, but then all of that healthy apple all around it. Then you have these things inside of your practice that start to pull meat off of that bone or the meal off of the apple core. You Obviously have to pay your providers. You need to cover supplies, lab fees need to pay your staff, need to take care of what we call occupancy costs, which is your rent and your utilities, basically anything and everything it takes so that the lights are on, patients can come in and be serviced. You have other costs like marketing it, accounting, other support services to ensure that your business, your practice, or your group of practices are being managed properly and compliant. And you're taking care of everything you need to in that business. Well, all those costs are like taking bites out of that turkey leg or taking bites out of that apple. And what you end up. So you start with this gross amount, which is that turkey bone that's covered with all that meat, or that apple core that's got that whole apple around it. And when you get down to the bottom, you have what's called net, and that is you're hoping that there's some meat left or some meal left on that apple or the meat on the turkey so that you can reinvest. And we want to build profitable dental practices. In fact, we have a responsibility to our patients and our clinicians and even our staff to be profitable so that we can take those profits and invest in technology and in improving the experience and remaining competitive in the marketplace. We want to have some of that left at the end. And that's called the net. So gross is it's all fully loaded up. It's all that money coming in. Net is what's left after everything goes out. Now, I use this as an example to help set the stage for talking about ebitda. EBITDA stands for earnings before interest, taxes, depreciation and amortization. And by the way, there are several ways to pronounce ebitda. I should just mention this. I've always said ebitda. Some say ebitda, some say ebitda, others say ebitda. And there are a few other versions going around. Not that any of them are wrong. Just want you to be aware that there's a few different ways to pronounce it. This concept of gross to net gets us to the E in ebitda, because EBITDA stands for earnings before interest, taxes, depreciation and amortization. The earnings, the E that's being referenced is the net income of your practice or your multiple practices. And that net income, or the E for earnings is the net. It's what's left after all those expenses, Everything is paid out of your practice. Hopefully you've got something left. Once all of that is said and done. So we start with this basis of earnings. We then add back several items. The B stands for before, so earnings before. So you get all the way down to that net income. And now it's like we're adding meat back onto the bone or we're adding part of that apple back onto the core to get to this EBITDA number, which again in the finance world, as we talked about in the last episode, is this nominalized way to remove financing and capital expenditures and other elements to create this nominalized way to look at what is the cash flow. It's a shortcut to cash flow. But what is the cash flow of the business? So that, so that anybody can take a look at that, compare it to others, compare it to other industries, and then apply a multiple to that based on how they feel about the future of the cash flow that your business represents. And that's how valuations are generally derived from in business or for any types of businesses. No difference for dental practices, group practices, or even those that are formally organized into DSOs. So we have this earnings, this net income before, which means we add back. And the first letter after the B is I, which is for interest. So any interest that you're paying out on equipment loans, or perhaps you also took out a loan for the TI in your business or you have other loans in order for you to have established your practice, interest is added back to this number again because the finance people want to be able to see the impact of removing financing costs to see what this core or nominal cash flow is called. Ebitda. The T stands for taxes. So assuming that the business doesn't pay taxes, they're adding this back just like the interest, as if there was no interest. They're now saying there's no taxes. So your earnings before interest taxes. The D stands for depreciation. Now, in a cash based business, you may not be calculating your depreciation throughout the year, but usually your tax accountant at the end of the year is doing, is calculating your depreciation and possibly even doing an accelerated depreciation because the tax code allows them to. And that can often be beneficial for practice owners. This depreciation is a concept of when you buy a fixed asset, which could be a piece of equipment, panoramic machine, a nomad, sensors, chairs, even cabinetry, furniture, fixtures and equipment, or all of these items fall under what's called a fixed asset. And when you purchase them, you don't get to expense them off of your profit and loss statement, but what you have to do according to GAAP and according to the tax code is you need to depreciate those assets over a period of time based on what their estimated lifetime value is. And then there's a salvage value that's attached to it as well. So you might buy a panoramic machine for $30,000 and say it's going to last me seven years and you depreciate that. And then at the end of seven years it has some small residual value that you could sell it for parts or sell it used to someone else who might be interested in that machine. So this depreciation number is actually a non cash item, but it impacts your net income. And so when we say earnings before interest taxes, we're adding those back. We're also adding back this concept of depreciation. Assuming that there's no capital expenditures in the business, these fixed assets that you've bought, there's no need to depreciate anything. It is a non cash transaction. And so it's adding it back to try to get a little bit closer to cash flow. And then the A stands for amortization. And amortization is a lot like depreciation, only it's when you purchase an asset that doesn't fall under the category of a fixed asset. So when you buy a business, let's say you go and buy another dental practice. Well, some of your purchase price is allocated towards fixed assets because you look and say, well, they have five chairs and they have two X ray devices and they have all of these different things that would qualify as fixed assets. But then the difference between your purchase price and, and the in subtracting out those fixed assets, that is has to be booked somewhere and it's generally booked as goodwill on a balance sheet that then has to be amortized over some period of time. And it's generally the value of patient charts, trade names, those sorts of things that aren't those fixed tangible assets. So there's this other item that gets booked, it's non cash. It's not as if you're paying somebody called amortization, but it's being calculated from a tax perspective and also based on the accounting rules. And once you take that out, you get down to this EBITDA number, which is where you got to your net income, your earnings and you add back interest, taxes, depreciation and amortization. And that brings you to this number of ebitda. Now it's not a perfect calculation for cash flow, it is a shortcut to get to cash flow. And it represents a number that the finance industry can look at and say, okay, we now understand if we remove financing, if we remove capital expenditure needs, we remove all that out. Here is a shortcutted way to look at what is the cash flow of the business. So I hope this has been helpful. Just to give you a little bit of context about what exactly EBITDA is. We talked about what it's been, what it's used for based on the last episode, but this will give you a little bit of detail. Got to go from a gross all the way down to the net income. And then we add back interest, taxes, depreciation and amortization and we get to that number. There you have it. That's ebitda. Exactly what it is, how it's calculated. Don't forget to join the DSO Secrets Facebook group where you can ask questions. You can also help answer questions from others within a community that Emmett's created to help each other. A dedication to trying to help each other along the path and along the journey. And as Emmett always says, until next time, keep smiling.

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