You may be hearing about practice sales where the purchase price was some multiple of EBITDA (E' bit dah). EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation & Amortization, and it represents net income with certain accounting expenses, namely depreciation and amortization, income taxes and interest expense added back in. For publicly traded companies, EBITDA is used to gauge a business' profitability as well as its ability to repay debt.
EBITDA is a particularly useful tool when applied to publicly traded companies, because these companies have financial statements that are regularly audited and prepared using rigorous standardized methods (GAAP accounting). GAAP (Generally Accepted Accounting Principles) is a complex, standardized method of recording a business's income and expenses. This allows potential investors to compare business to business and industry to industry. Many small businesses don't use GAAP because the complexity creates additional accounting expense.
EBITDA is easy to calculate using an income statement or an income tax return. It merely involves adding together net income and four expenses: interest, income tax expense, depreciation and amortization. In the veterinary profession, more attention is paid to true profitability rather than EBITDA, but calculating profitability is not as simple as adding five numbers together. Every veterinary practice is unique, and every practice owner has distinct financial objectives. In calculating the profitability of veterinary practices, the goal is to remove some of the variability created by decisions made to mitigate taxes, pay off debt, replace and upgrade equipment, or to fund specific activities or charities.
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Factors considered
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EBITDA
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Profitability
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Net income
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Interest
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Income taxes
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Depreciation expense
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Amortization expense
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Equipment replacement
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Owner comp/benefits
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Family working in practice
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Facility rent
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Charitable contributions
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Other discretionary spending
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EBITDA is hard to apply to veterinary practices because there is no standard financial system or practice management software, and setup varies from one hospital to the next. In addition, veterinary hospital owners and managers generally make decisions designed to enhance patient care, client service or staff morale, not to increase profit.
Equipment
One problematic aspect of an EBITDA calculation relates to adding back depreciation expense without consideration for routine equipment replacement. Depreciation is the method used to "write off" large equipment purchases. EBITDA calculations ignore the critical spending related to on-going investment in equipment replacement and upgrades. A practice that does not regularly invest in new equipment and technology will struggle to achieve a competitive advantage in the marketplace. Veterinary hospital profitability calculations include an annual equipment acquisition allowance that varies somewhat based on practice type.
Owner Compensation and Benefits
Hospital owners choose their own pay and benefits structure and owner compensation varies significantly from practice to practice. EBITDA does not reflect what a different owner would pay him/herself, nor does it account for differences in benefits provided. Veterinary valuation experts analyze owner compensation and may adjust that compensation up or down to reflect what a different owner should reasonably expect to receive in compensation. This calculation is based on "the substitution principle." We replace the actual spending on owner salary and benefits and substitute it with what you would need to pay an associate veterinarian or manager to do the same work that the owner is doing. If the practice owner is a veterinarian, we will substitute the owner's salary with the amount that would be paid to an associate with similar experience to generate the same level of production. There is also a substitution made for the owner's role in managing the practice and what a manager would be paid to do the same things. This adjustment will increase profitability if the owner is paid more than others would receive. Profitability will decrease if the owner is paid less than what others would earn for the same work.
Many small businesses hire members of the owner's family, and veterinary hospitals are no exception. Sometimes those family members are paid handsomely; other times they are paid a pittance or not at all. Practice appraisers will adjust profitability to reflect what a third party would be paid to do the same work. EBITDA does not address family member compensation.
Facility Rent
Facility rent is another area that may vary somewhat when the practice owner is also the owner of the real estate from which the practice operates. Again, mostly dependent on tax mitigation strategies determined by the hospital owner's CPA, the amount paid for facility rent may or may not reflect the fair market value of the property. Practice owners may pay significantly more or significantly less than what an unrelated party would expect to pay to rent the practice's facility. This is a common tax strategy employed by owner veterinarians, but it is not addressed by the EBITDA calculation.
Other
Other expenses that reflect a practice owner's personal values and interests affect profitability but not EBITDA. Examples include discretionary spending on resort CE, charitable contributions, personal vehicles and tickets to sporting or cultural events. When there is not a clear division between the owner's personal spending and the expenses of the business, profitability will artificially low.
Summary
While EBITDA is a useful measure of business performance for publicly traded companies, it is difficult to apply to privately held businesses that do not follow strict accounting guidelines. Veterinary hospital owners make decisions every day with more emphasis on patient comfort and care and less regard to profitability and sales price. EBITDA is not the most accurate method for calculating profitability or practice value. If someone offers to buy your practice for a multiple of EBITDA, you may be leaving money on the table.
