EBITDA or Earnings before Interest, Tax, Depreciation, and Amortisation is one of the most popular measures of a company’s operational success. Regardless of that, it only reveals a company’s profit and not profitability. To assess profitability, investors utilise another metric called the EBITDA margin.
EBITDA ratio refers to the relationship between a company’s net sales and operating profit sans the effect of depreciation & amortisation. There are different variants to EBITDA, namely – EBIT and EBITA.
This measure is more useful to gauge a company’s financial health and operational profitability. That is because this metric does not recognise the extraneous costs of depreciation & amortisation, taxation, and interest on debts.
EBITDA is unique as a financial metric due to its near-accurate representation of a company’s profitability and also cash flow. However, it is a non-GAAP metric as opposed to its other counterparts.
As mentioned previously, the EBITDA margin defines the relationship between a company’s earnings and total revenue. Regardless, since EBITDA is not mentioned in a company’s financial statements, analysts and investors need to calculate it by themselves.
EBITDA margin calculation is derived from net sales by deducting two primary categories of expenses. These are –
The cost of revenue, as the name suggests, refers to such expenses that directly stem from revenue-generating operations. Therefore, in other words, such expenses are variable because they vary with changes in production.
A few expenses that come under the gamut of cost of revenue are –
However, according to GAAP ( generally accepted accounting principles) guidelines, any organisation must write the cost of revenue as a separate line item in the Income Statement. Gross profit is calculated after deducting the cost of revenue from total revenue.
Administrative overhead refers to all the expenses incurred from a company’s day-to-day activities. In other words, those expenses are necessary owing to a company’s functional dependency on them.
Some expenses that come under the ambit of administrative overhead are –
Administrative expenses can be categorised as fixed or semi-variable, as opposed to the cost of revenue that includes only variable costs.
Once the categories described above of expenses have been identified, it is simple to calculate EBITDA using the following formula –
EBITDA = Total revenue – Cost of revenue – Administrative expenses
To calculate this metric one needs to follow the below-mentioned EBITDA margin formula –
EBITDA margin = Total revenue – (Cost of revenue + Administrative expenses) / Total revenue
Or, EBITDA margin = EBITDA / Total revenue
Example: Let’s consider an excerpt from Godrej Industries’ Income Statement as of 30th March 2019.
|Amount (in Rs. Thousands)
|Cost of revenue
|Selling, general, and administrative expenses
|Research and Development
EBITDA does not admit interest and income tax under its calculation. Therefore, the EBITDA of Godrej Industries for FY 2018 – 19 is, EBITDA = Total revenue – (Cost of revenue + Selling, general, and administrative expenses + Research and Development)
Or, EBITDA = Rs. [111371000 – (86577100 + 2243800 + 39700) = Rs. 50,64,000
Therefore, EBITDA percentage= EBITDA / Total revenue
Or, EBITDA margin = 5064000 / 111371000 = 0.0455 or 4.55%
The EBITDA margin is a prominent indicator of an organisation’s financial standing with respect to the total revenue. That is because it suggests how much cash a company can generate against Re.1 of its revenue sans external and non-operational costs.
Therefore, a high EBITDA percentage denotes a robust and well-managed cash flow and low operational expenses. Furthermore, this metric is also a representation of the success of a company’s cost-cutting ventures.
One of the primary advantages of EBITDA is it facilitates comparison between two companies belonging to the same industry but with comparatively higher or lower market capitalisation.
For instance, let’s assume there are two hypothetical companies from the consumer durables industry – Company G and Company I. Company G’s revenue for the fiscal year 2019 – 20 is Rs.6 lakh. The company I’s revenue for that period is Rs.60 lakh. EBITDA of Company G and Company I are Rs.4 lakh and Rs.25 lakh.
Therefore, Company G’s EBITDA margin would be 66.67% and the same for Company I would be 41.67%. Ergo, even though Company G had a much lower revenue generation in comparison to Company I, it is better managed and more cost-efficient than the two.
EBITA is an ineffective measure for companies that rely on substantial amounts of debt. As mentioned previously, it excludes the likes of interest expense. Therefore, EBITDA margin cannot be a reliable metric for assessing the financial health of such companies.
Also, some companies that heavily rely on debts for cash inflow can put more stress on their EBITDA margin instead of net profit margin to lure in investors.
As mentioned earlier, EBITDA does not fall under GAAP guidelines and is a measure computed by companies at their own discretion. Ergo, without accounting regulations, companies can indulge in unfair practices and skew their EBITDA to exude a positive image to investors.
Operating margin refers to the ratio between a company’s operating income and net sales. EBITDA and operating profit are often used synonymously by analysts and investors. That is because if a company does have assets that realise depreciation and amortisation, its EBITDA is similar to its operating income. Consequently, their operating margin and EBITDA percentage would also be similar.
When comparing EBITDA margin with operating margin, the former is a better indicator of a company’s financial health and cash flow. This is because EBITDA does not account for extraneous expenses like depreciation & amortisation, which somewhat compromises the analysis.
Net margin denotes the ratio between a company’s net profit and total revenue. Thence, net margin includes income from other sources as well as depreciation & amortisation, interest expense, and taxes.
Net margin is more suited to the assessment of companies that involve considerable amounts of debt compared to EBITDA.
In conclusion, the EBITDA margin shall be used in conjunction with other such metrics to develop a more wholesome understanding of a company’s financial health.