EBITDA: A Deeper Understanding

We love using acronyms. Dentists use them — TMJ, RDH, DDS. Bankers use them — APY, IRA, ACH. However, just because we use them does not mean people outside our industries understand them.

The same goes for different generations. I don’t understand half the texts I receive from my nieces — ROFL? YOLO? SMH? Now I’m showing my age.

In the DSO world, a common acronym is EBITDA. It is often overheard during happy hour at conferences — “What’s your EBITDA?” That is a good question. Depending on how you look at it, there can be different answers. EBITDA is the best gauge for both investors and banks to understand the operating profitability of a business. So, what is EBITDA?

What is EBITDA and Why is it Important?

Simply put, EBITDA means Earnings Before Interest, Taxes, Depreciation and Amortization. EBITDA is used not only to analyze your own profitability but used to compare your business to others in the industry. When looking to buy or sell a group of practices or partner with private equity, EBITDA is the ideal metric to determine the enterprise value based on a multiple. Banks also use EBITDA as a denominator when calculating leverage ratios, or how much they are willing to lend to a DSO.

It is extremely important to capture the correct EBITDA or else it may be difficult to find a bank or equity partner. All too often, I find emerging groups will miscalculate their EBITDA, often overstating it as a result of including officer compensation or only looking at practice level EBITDA, also referred to as “4-Wall” EBITDA. COVID-adjusted EBITDA became common more recently to account for losses caused by practice closings due to the pandemic. Fortunately, the COVID noise will soon be behind us.

Another common acronym, TTM, or trailing twelve months, will be used to gauge EBITDA in the coming months. TTM EBITDA will show a more accurate portrayal of EBITDA during normal conditions. With all these variations, which EBITDA should be used?

Calculating EBITDA

Below is a standard definition used when calculating EBITDA:

Adjusted Post-Corporate EBITDA shall mean (a) Net Income, plus (b) to the extent deducted in the calculation of Net Income (i) Interest Expense, plus (ii) depreciation expense and amortization expense, plus (iii) federal and state income tax expense, plus (iv) transaction costs and expenses incurred by the Loan Parties in connection with any Permitted Acquisitions, whether or not consummated, not to exceed $320,000 per transaction, plus (v) extraordinary, non-recurring and/or non-cash losses or expenses as approved in writing by the Bank, minus (c) extraordinary, non-recurring and/or non-cash gains or income as approved in writing by the Bank.

Although lengthy, it is quite simple when you break it down. When looking at the EBITDA of the enterprise, one must not only factor in practice-level EBITDA, but also include EBITDA of the management company. This gives us a consolidated EBITDA calculation of the DSO in its entirety. Let us break down this definition by each bolded selection.

(a) Net Income, plus(b) to the extent deducted in the calculation of Net Income (i) Interest Expense, plus (ii) depreciation expense and amortization expense, plus (iii) federal and state income tax expense,

 This is the standard definition of EBITDA and includes both the practices and management company.

plus (iv) transaction costs and expenses incurred by the Loan Parties in connection with any Permitted Acquisitions, whether or not consummated, not to exceed $320,000 per transaction,

Acquiring a practice or a group of practices can be expensive. Quality of earnings, legal fees, ordering other due diligence reporting and closing costs can add up. Usually, your bank will allow the DSO to add back these nonrecurring expenses up to a certain amount. In this example, that’s $320,000. This will vary depending on the size of the DSO.

plus (v) extraordinary, non-recurring and/or non-cash losses or expenses as approved in writing by the Bank, minus (c) extraordinary, non-recurring and/or non-cash gains or income as approved in writing by the Bank.

There are many types of nonrecurring items such as litigation fees, losses from the sale of an asset or other business write-offs. Just like losses, nonrecurring gains are not included. In some instances, businesses attempted to record EIDL loans and Payroll Protection Program loans as income in 2020. These would not be accepted.

Now What?

It is important to correctly calculate your DSO’s EBITDA, as it is an important tool to determine your company’s value and bankability. If you are looking for a lending partner, equity partner or even looking to buy or sell a practice, know your worth. Consider the following:

  • Who handles the bookkeeping?  How detailed are your profit and loss statements and are they completed monthly?
  • Are your EBITDA margins aligned with industry averages? What can be improved?
  • Do you conduct monthly Key Performance Indicators to assess your overall financial health?
  • Do you have a CPA that understands your business and provides both separate and consolidated financials?
  • If you are in the market to sell, have you had your DSO valued by an advisor?

Now is a good time to calculate your EBITDA
and assess your goals for 2021.
Let us know how we can help – one acronym at a time.

Written by Mike Montgomery
Vice President and Founder of the DSO Division of Live Oak Bank 
Email Mike: [email protected]

 


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