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What’s it: EBITDA margin is a profitability ratio to measure how much a company profits from recorded revenue after adjusting for non-cash items but before paying interest and taxes. We calculate it by dividing EBITDA by revenue, expressed as a percentage.
Earnings before interest, taxes, depreciation, and amortization (EBITDA) is a proxy for cash profits generated by the company during the reporting period. We exclude non-cash items, namely depreciation and amortization, from the calculation to obtain EBITDA. Thus, it is closer to the cash generated by the company. So, we can say EBITDA margin shows how successfully the company converts each revenue into cash profit.
Examining the EBITDA margin is useful for comparing a company’s performance with peer companies in its industry. A higher ratio is better because the company makes more money for each sales dollar. The opposite condition is worse.
What is EBITDA? And why is EBITDA margin important?
The EBITDA margin tells us how many dollars are left for each sale the company records. It is a profitability metric and reflects how efficiently a company generates cash. Examining them helps us measure how effectively management generates revenue and manages costs.
EBITDA is a profit metric widely used in financial analysis. It focuses on a company’s financial performance by relating its operating profitability and cash flow. Since we excluded non-cash items when calculating it, it is the closest proxy for how much cash the company generates.
We add back depreciation and amortization because these costs are unavoidable. They represent the lost economic value of fixed and intangible assets during the accounting period. However, unlike other expenses, they do not cause cash outflows due to non-cash items.
Then, EBITDA also eliminates the financing and tax burden effects when we measure earnings. Thus, it is not sensitive to companies’ leverage levels and tax rates variations. For example, the two companies have different debt levels, so the interest expense paid is also different. Since we exclude interest expense, the two are more comparable when using EBITDA.
How to calculate EBITDA margin?
Calculating EBITDA requires us to look at the accounts on the income statement. First, we subtract revenue by the cost of goods sold and operating expenses such as selling, general and administrative expenses. Then, we add back depreciation expense and amortization expense.
Second, after obtaining the EBITDA, we compare it to revenue to obtain a margin figure, expressed as a percentage. Here is the formula:
- EBITDA Margin = EBITDA / Revenue
Now, take a simple example. A company posted revenue of $2 million and EBITDA of $200,000. In this case, the EBITDA margin is 10%.
As a note, some people may have a different approach to calculating EBITDA. They might start with net income, then add back taxes, interest, depreciation, and amortization. This approach accommodates non-operating gains and losses in the calculation, unlike the first approach above.
Whether it is necessary to include non-operating gains and losses is at the discretion of each of us. But, we must remember, non-operating items tend to appear one time or are not recurring, resulting in EBITDA tending to fluctuate. Moreover, these items tend to be unstable, sometimes rising significantly in the previous period and sometimes falling sharply in the next period.
How to interpret the EBITDA margin?
In general, a higher EBITDA margin is better. That indicates the company is effective in generating profits and efficient in managing costs. Thus, the company makes more dollars for each product sold – the company earns revenue at a lower cost. And, the higher the ratio, the lower the operating costs, relative to revenue, and the more money it makes.
In contrast, a low ratio is less favorable. For example, companies may have problems managing operations efficiently, so operating costs tend to be high. Or, the marketing strategy is less effective, so less revenue is generated from selling the product.
Then, comparing historical EBITDA margins gives us insight into the company’s performance over time, improving or deteriorating. If the margin increases, it is desirable to indicate an improved performance.
Then, since there is no guide to ideal ratios, we also need to compare the ratio with peer companies or industry averages to learn how well the company is performing compared to its competitors. A higher ratio indicates better performance, indicating superior to its competitors.
Leverage effect
EBITDA margin has a weakness in evaluating the company’s overall profitability. For example, a company with high debt may have high EBITDA margins. At first glance, the company is performing well and has no problems with profitability. However, that may not be entirely true.
When we factor in interest expense, for example, by using pretax profit as the numerator, the company’s profitability may not be as good as the EBITDA represents.
Pretax profit margins could be much lower due to the high-interest expense. Since interest has to be paid, this situation implies that less profit is available, either to shareholders (as dividends) or held as internal capital.
For this reason, some companies focus more on EBITDA margins than other profit margins to influence investors in how they perceive their financial performance. And, for those who don’t examine financial performance more closely, the numbers can be misleading.
Amortization and depreciation effects
Comparing EBITDA margins between companies can be misleading because they may use different assumptions and methods in recognizing depreciation and amortization. As a result, they can report vastly different figures even though they have relatively similar fixed and intangible assets. For example, one company may report high depreciation and amortization, leading to higher EBITDA figures. While others show the opposite condition.
Several factors affect reported depreciation and amortization – and therefore EBITDA, including the methods used and assumptions about the asset’s useful lives and residual values. For example, the straight-line depreciation method recognizes expenses evenly over the asset’s useful life. In contrast, the accelerated depreciation method recognizes a higher expense early in the asset’s useful life and decreases over time. Thus, if two companies buy assets simultaneously at the same price, the company using the straight-line depreciation method will have a lower depreciation expense than the accelerated depreciation method.
