The consolidation of the dental industry into the hands of investment groups has resulted in the spread of various financial terms that are often misunderstood and misapplied. The most common of these terms is EBITDA. Spend time in the Wall Street district of New York City, and you will likely encounter people whispering mischievously about the varying levels of EBITDA they encountered during their workday. To anyone who has not had the satisfaction of delving into the inner workings of the mysterious mergers-and-acquisitions realm, the term can sound quite baffling. While it is difficult to pronounce and appears confusing to define, the underlying concept is simple to understand once you have a clear picture of its intended use.
What is EBITDA?
Let’s begin this journey by breaking down the acronym itself. In its separated form, EBITDA stands for Earnings before Interest, Taxes, Depreciation, and Amortization. Simple enough, right? You are likely disappointed that a deep secret of the multiverse was not revealed. What is revealed is a metric that will allow you to peer more deeply into your Practice’s inner workings!
To add a layer of complexity, an additional adjustment of “normalized dentist compensation” is often included in the EBITDA calculation. This expense adjustment can either be an expense addition or reduction, but intends to adjust the historic owner dentist compensation to a “normalized” amount, as the owner of a practice can compensate themselves however much or little they deem reasonable. In practice, this EBITDA is more accurately represented by “EBITDA(nc),” where “nc” represents the normalized compensation adjustment.
At its core, EBITDA(nc) is a financial metric that enables comparison and analysis of financial statements across a variety of dental practices and specialties. It can also serve as a metric on which investors can, and often will, base their investment dollars. You are probably wondering why these particular expenses are removed and what the significance of this new profitability calculation is. The precise answer to that is this: every business operates differently, and every business owner can run their business however they may choose. When calculating EBITDA(nc), the goal is to remove a portion of the variability that often arises from management decisions.
Removing interest expense creates a clearer picture of the business by eliminating discretionary and/or personal financing decisions made by the current owner. By removing taxes, we eliminate the individual tax situation of the owner caused by their location and entity choice, such as an LLC, sole proprietorship, or S-Corp. By removing depreciation and amortization, we are removing a non-cash expense in which the timing was a discretionary decision made by current management. While it can seem confusing at first glance, EBITDA(nc) ultimately yields a numerical figure that more closely reflects the practice’s cash flow while eliminating the discretionary timing of financing and investment decisions made by the current or previous management team.
Having established the definition of EBITDA(nc) and its components, we can now move on to common uses and limitations.
Common Uses and Limitations
Since the emergence of Dental Service Organizations (DSO) into the dental industry, EBITDA(nc) has become a commonly used figure amongst dental practitioners, often leading to inflated and misguided beliefs about the private party value of one’s practice. Depending on the source, we can estimate that roughly 20% of all US-based dental practices are affiliated in some capacity with a DSO (Dental Service Organization), and that figure is only on the rise. As DSOs have the advantage of streamlining certain practice expenses, they are often able to purchase practices for values well above what a private, individual buyer would be willing to pay or obtain financing for. These organizations will often evaluate and purchase practices for EBITDANC multiples within the range of 5 to 7, whereas the multiple for private buyers will often range from 3 to 5.
If you are a practice owner and have little interest in selling to a DSO, EBITDA(nc) is not going to be as critical of a component in the selling process, as most private buyers are simply not evaluating practices under the same investment criteria compared to more profit-driven, equity-backed DSOs. Therefore, many private owners looking to sell and private buyers looking to purchase a practice can often have an overinflated sense of value when they solely apply EBITDA(nc) to their investment criteria, as it ignores several key financial considerations and can mask certain deficiencies.
First, EBITDA(nc) ignores necessary capital or equipment improvements, as it does not account for past or future capital expenditures. Second, it is not a true representation of cash flow and does not fully portray the financial position of the current or future owner, by either including or excluding certain expenses. Lastly, EBITDA(nc) can often mask financial distress, as it completely removes interest expense and can mask an over-leveraged practice unable to meet debt obligations due to a variety of underlying issues. For instance, depending on who prepares the EBITDA(nc) calculation, the removal or reduction of certain discretionary expenses or “normalization” adjustments could over-inflate the figure if scrutiny and diligence are not applied across all assumptions in the calculation. Therefore, it is critical for any potential buyer or seller of a dental practice to put into question the legitimacy of all expense adjustments and if those adjustments will remain true in future periods.
In summary, EBITDA or EBITDA(nc) is nothing more than a financial tool that offers a certain view into the financials of a dental practice. Still, it does not show the whole picture and should not be relied on exclusively when determining the appropriate value. If looking to sell your dental practice or are looking to acquire a practice, this metric should serve as nothing more than tool in your investment diligence tool chest, alongside all other financial and personal considerations. In operating a practice, as in life, what you choose to ignore often matters as much as where you place your focus.
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Blue & Co.’s Dental Practice Team works with over 400 dental practices each year, providing a variety of services that add value to dentists by allowing them to focus on the clinical management of their practices. We prepare our dental clients throughout the year to strategically plan for ways to reduce tax liability and have appropriate cash flow to pay tax bills. Reach out to a member of our Dental Practice Team below or your local Blue & Co. advisor.
