Earnings before interest, tax, depreciation and amortization over net sales

What is EBITDA Margin?

EBITDA margin is a profitability ratio that measures how much profit the company is earning before taxes, interests, depreciation, and amortization in relation to total revenue. The earnings include net income derived from operations. Operating expenses, such as: cost of goods sold, selling general & administrative, are deducted from the gross operating profit, excluding depreciation and amortization.  Overall, it does not include in the calculation the company’s capital, non-cash expenses, and tax incomes. This ratio may be used in conjunction with other leverage and efficiency ratios.

What is the Formula for EBITDA Margin?

The first step to calculate EBITDA is to get the earnings before interest and tax (EBIT) from the income statement. The next step is to add back the depreciation and amortization expenses.

EBITDA = Operating Income (EBIT) + Depreciation + Amortization

To compute for the EBITDA ratio the following formula is used:

EBITDA Margin =  EBITDA / Net Sales   

To illustrate:

LMN company declared a net profit, before taxes and interest, of $3M for year-end 2015. Net sales reported in the income statement show an amount of $5M, as well as depreciation and amortization of $100,000. Given the figures, EBITDA margin is calculated as 62%, implying that the remaining 38% in sales revenue accounts for the operating expenses. The higher the EBITDA margin, the smaller a company’s operating expenses in relation to total revenue, increasing its bottom line and leading to a more profitable operation.

What are the Benefits of Using EBITDA Margin in Determining Business Profitability?

EBITDA margin is considered to be the cash operating profit margin of a business. It eliminates the effects of non-cash income and non-cash expenses as well as taxes. Investors and owners can readily understand how much cash is generated for every dollar of revenue earned and use the margin as a benchmark in comparing various companies. EBITDA is widely used in mergers and acquisitions of small businesses and businesses in the middle market. It is not unusual for adjustments to be made to EBITDA to normalize the measurement, allowing buyers to compare the performance of one business to another.  A low EBITDA indicates that a business has profitability problems as well as issues with cash flow. On the other hand, a relatively high EBITDA means that the business earnings are stable.

What are the Drawbacks of EBITDA Margin?

Since EBITDA excludes debts, non-cash expenses, interests and taxes, some companies misuse this as a way to increase the image of their financial performance. For companies with high debt capitalization, EBITDA margin should not be applied, because the larger mix of debt over equity increases interest payments, and this should be included in the ratio analysis for this kind of business.  A positive EBITDA does not necessarily mean a business is generating cash. This is because EBITDA ignores changes in working capital, which is usually needed in growing a business’s capital expenditures when needed to replace assets that have broken down, as well as in taxes and interest. Lastly, EBITDA margin is not recognized in generally accepted accounting principles.

Famous investor Warren Buffet has expressed his disinterest in the use of EBITDA margin.

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