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What’s it: EBIT margin is a profitability ratio to measure how efficiently a company converts its revenue into profit before paying interest and taxes. We calculate it by dividing EBIT by revenue. A high ratio is better because the company can translate the revenue earned into more profits.
This profit margin ignores its funding strategy because it excludes interest from the calculation. Likewise, we also exclude taxes to obtain the EBIT figure – thus, it is not affected by variations in tax rates between different jurisdictions.
How to calculate EBIT margin?
First, we must get the EBIT number to calculate the EBIT margin. The company may not present it as a separate account on the income statement. Thus, we have to calculate it manually – I explain below.
Then, after getting EBIT, we divide it by revenue. Here is the EBIT margin formula:
- EBIT Margin = EBIT / Revenue
Take a simple example. A company posted revenue of $4 million. The company bears COGS of $2 million and operating expenses of $1.2 million to make this revenue.
In that case, the company posted an EBIT of $800,000 = $4 million – $2 million – $1.2 million. Thus, the EBIT margin equals 20.0% = $800,000 / $4 million.
Some analysts may start calculating EBIT from revenue. They then subtract it by the cost of goods sold (COGS) and selling, general and administrative expenses (operating expenses). In this case, it would be equal to operating profit because it ignores non-operating gains (losses). They exclude non-operational items because they are relatively small in value and are less likely to recur in the future.
- EBIT = Revenue – COGS – Operating expenses
But, in other cases, analysts calculate EBIT by adding back interest and taxes to net income. Thus, different from the previous approach, this calculation includes non-operating gains (losses).
- EBIT = Net income – Interest – Tax
Which is more appropriate of the two approaches above depends on our discretion. Including non-operating items can make EBIT numbers tend to be volatile. However, excluding them can affect EBIT figures because their value may be significant in certain cases.
How to interpret EBIT margin?
As we interpret other profitability margins, a higher EBIT margin is better. The increase shows the company has managed to convert revenue into more profits. In other words, the company earns revenue at a lower cost. Thus, revenue increase more than the increase in costs.
On the other hand, a low EBIT margin is less desirable. It shows the company is less efficient in operating. Thus, the company can only convert revenue into less profit due to high costs. As a result, less profit is available to pay interest to creditors and taxes to the government.
Historical comparison
Comparing EBIT margins historically is important for evaluating whether a company generates revenue and manages costs better. For example, when margins increase over time, it indicates improving conditions as the company manages to book revenue at a more efficient cost.
Companies may have higher gross profit margins due to switching to a differentiation strategy. Thus, the profit margin per unit sold is relatively high because it charges a premium price. At the same time, the company manages costs efficiently as before.
Comparison with peers
How high is the ideal EBIT margin? We should compare it to the normal in the industry. Suppose the average EBIT margin for all companies in the industry is relatively low. In that case, it may be due to external factors such as intense competition.
All companies in the same industry will face the same threats and opportunities. However, how well they deal with it all and make better profits depends on the strengths and weaknesses of each company (internal factors).
Thus, if a company posts slightly lower-than-average EBIT margins, it is likely due to poor strategy or management. For example, a company may book lower sales volume due to poor marketing and product. At the same time, the company faces higher costs than its competitors, for example, due to low economies of scale.
Why use EBIT margin?
EBIT margin is a profitability metric without considering the effect of interest and taxes. Specifically, it describes efficiency because we compare the remaining profit with revenue. And an efficient company is when it manages to generate revenue at a low cost.
Assess how profitable the core business is
Now assume we analyze a manufacturing company. If we calculate EBIT excluding non-operating items, we will gain insight into how profitable the company’s core business is. EBIT is not affected by items such as translation gains (losses) and interest income, which are not related to the core business. It only takes into account the daily operating income and expenses.
When we evaluate a company, we have to examine its core business because that is what will bring in revenue in the long run. Thus, when we evaluate how successful a manufacturing company is, we examine how much revenue is made from selling the product and the costs involved are, not how much profit from fluctuations in exchange rates or investing cash in securities.
Not distorted by interest and taxes
Variations in tax and financial leverage can make profit margins between companies less comparable. Take the net profit margin as a case. To get it, we deduct interest and taxes. So, how high the leverage is and how much tax is paid will affect the figure.
In contrast, interest expense and taxes do not affect EBIT because we exclude them from the calculation. Thus, we treat all companies equally regardless of whether or not they rely more on debt to finance operations and whether or not they operate in high-tax jurisdictions. For this reason, we can also say EBIT represents the profit available for the company to pay interest and taxes. So, if it’s higher than both, it’s better.
