43: What EBITDA is not

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You have this natural talent, this unique ability. Hello, everyone, and welcome to another episode of DSO Secrets. I am Ken Kaufman, your guest host today, filling in again for Emmett Scott. I'm talking about Ibitdah. And this episode will be the third in a third part series on first, the fascination with ebitda, especially in the DSO space, what EBITDA is exactly. And then today we'll be covering what EBITDA is not. And I believe that understanding what it is not and what it does not represent is possibly one of the most important things for you to understand about this measurement. So in my role as a chief financial officer, and I've been that for several businesses, I want to represent to you a conversation that I've had dozens of times. But just for anonymity and to not point fingers at any one specific person, I'm just going to mesh all those experiences up into one concept that I'm going to share with you. I go to a bank representing a company, and I speak with the banker and express our interest to raise debt financing. Now, you could insert equity financing here or mezzanine debt financing, or you could really go down any one of those potential financing routes. But in this case, I'm going to pick a traditional banker at a traditional banking institution that loans money, sometimes referred to as a senior lender or a secured lender. So I go to this banker and I bring all the financial statements and information and give them all of that information. They take some time to get familiar with the company, run their, what are called spreads to see exactly what's happening in the business from a financial standpoint. And then they always come back to me and say, okay, tell me exactly what it is you want and what you're going to do with the funds that you want. I then very methodically go through what's called the sources and uses list, where we list out all the ways that we're going to use the capital and how that's going to add value to the business. I then take that back and say, here's how much we're asking for and this is what we're going to use the funds for. And generally speaking, those uses need to show that it's going to create a return and it's going to create cash flow in the business to pay back that loan and then some. Or pay it back, you know, multiple times so that it adds value to the business, doesn't even just pay the debt back. So once I give that sources and uses list, the banker then goes back. And without fail, traditional bankers always come back and say, you're asking for too much. You don't need that much. This has happened enough that I know that it's going to happen. And I am prepared for the conversation when they tell me I'm asking for too much. And by the way, sometimes equity players tell you you're not asking for enough, but we're going with traditional banking. They say, you're asking for too much. And I'll say, well, why is it that you feel that way? And they'll come back and say, well, we think that you've underestimated your cash from operations and we believe that operationally you'll be able to fund some of these projects or purchases without needing to use our debt to do it. I will then say, and this is the critical point. Great, I appreciate that perspective. Tell me how you got to that number. And without fail, here's what happens. They come back and they say, well, I took your EBITDA and I then made a couple of adjustments here and there, and it looks like you're generating this much cash flow in your business, and we think that some of that can be used for this project and you don't need to borrow quite as much from us. Well, they're obviously trying to minimize their risk as best as they can and be safe. And I completely understand that. But here's the problem. EBITDA is not your cash flow. EBITDA is a lazy shortcut to a nominal cash flow number that removes the effects of financing and capital expenditures and amortizing goodwill purchases and those sorts of things. It takes all that stuff and nominalizes it so that finance people can take a look and see what's happening. But the one problem that finance people always create, or I should say that they always forget, is that EBITDA is not the actual cash flow of the business. I need to just say one more time, EBITDA is not the actual cash flow of your business. It is a lazy person's shortcut to this nominal cash flow number. So you'll say, well Ken, I don't understand then why, what is EBITDA really measuring? Or what? Why is EBITDA on my cash flow if the banks all talk about it that way? Well, again, it's that nominal number for comparison and to come up with valuations. But here's why. EBITDA is not your cash flow and really ultimately what EBITDA is not. Remember, EBITDA stands for earnings before interest, taxes, depreciation and amortization. Okay, the D and the A depreciation, amortization, I'll give that to you. Those are non cash items that has nothing to do with the cash flow in the business. Great, I am fine with that. I get that. However, the T stands for taxes and you actually have to pay taxes in your business, yet they somehow forget to add that into this cash flow concept that they're putting together when they run ebitda. It also misses the I, which is for interest, which on the back end of that is debt, principal payment. So if you have a loan that is amortized over a period of time where you're paying both interest and principal, both of those are excluded from EBITDA's calculation of cash flow. So you can see really quickly just between interest and principal repayment and taxes, all of a sudden this EBITDA number is far away from cash flow. But it's worse. It also does not account for any capital expenditures you need to make in your business. Now, we're all in the dental business here and we are assisting and supporting and helping dental practices. I've benchmarked this with small dental pract, larger multi group practices, and even some of the biggest DSOs. Each one of them will tell you that capital expenditures on a maintenance basis, so just to keep a practice up and running and successful is 2 to 4% of your net revenue or net collections each year. A sensor goes down, a pan machine goes down, you need to fix up a few dents in equipment and perhaps there's some holes in some drywall or you need to just put new flooring in. You have all these capital expenditures that are not accounted for, but at least 2 to 4% of your net revenue is needed just to keep the practice up and running and functional. Again, another huge miss if you're talking about EBITDA is the actual cash flow of your business, which it is not. Again, I'll say it again, it is a lazy person's shortcut to your cash flow. So again, interest, taxes, debt repayment, now capital expenditures. And then the last one that sometimes really has, has the finance people of all people scratching their head. And it is the absorption of your profitability into what's called the working capital cycle. So let me give you an example. Let's say that you're taking on a new specialty aligner. Seems to be something that's pretty common out there. And there's a pretty significant upfront cost to have those aligners made and then shipped to your office. And then whatever your process is for distributing those to your patient and then following up with them and making, making sure everything is progressing as it should according to the treatment plan, there's a big upfront expense to that. Well, that's not accounted for when somebody's trying to look forward at what your cash flow is. When you take on new specialties, new modalities, new capabilities, you might see your supply costs needing to go up and you needing to have more inventory on the shelf for some of those things that gets, that's a, an example of working capital absorbing some of this profitability that you're generating or this, you know, cash flow that you're generating from this nominalized EBITDA perspective. And so as the working capital cycle absorbs that, it means that there's actually less cash flow available than somebody who's using this EBITDA number will find. You might also find your receivables are growing because insurance companies are slowing down in how they pay. Or maybe they're, they're going down because you're getting paid faster. Oh, we all wish that that would be the case. Then we have also, you have patient finance plans. That's another critical part of you're waiting for payment in the future. But you might be recognizing that income earlier on. And you, when somebody's looking at cash flow, it looks like there should be more cash flow there according to ebitda, but it's not. So what EBITDA is not. It is not your actual cash flow. There's nothing wrong with ebitda. I'm not saying that we shouldn't use it or rely on it, but it's for a purpose of comparison and for driving to evaluation of a business. It is not about your actual cash flow. Don't let your banker use it. Don't let your equity partners use it. The only thing that represents your true cash flow is your actual cash flow, which is a connection of your profit and loss statement to your balance sheet, to your statement of cash flow, and then forecasting that out according to all those changes in your business. You have capex, you have interest, you have debt repayment taxes, and then you have the absorption into your working capital cycle of some of that cash flow. Depending on what changes are happening in your practice, day to day, week to week, month to month, year to year. Well, there you have it. What EBITDA is not can't thank you enough for joining. Don't forget to join the DSO Secrets Facebook group where Emmett's worked really hard to have a community where you can both ask questions and you can also jump in and help answer questions that you have information to share about. As Emmett always says, until next time, keep smiling.

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