Knowing what is EBITDA and how to calculate its margins can give a valuable insight into how much a specific business has profit potential, so we will outline all facts regarding this profitability parameter.
Key Points
- EBITDA is an acronym of a business term Earnings Before Interest, Taxes, Depreciation, and Amortization.
- This profitability parameter shows the revenue portion that stays in the company after certain operating costs (e.g., material cost, salary cost, etc.) are paid.
- The EBITDA margin is a metric that measures a company’s operating profit as a percentage of its revenue.
- The main disadvantage of EBITDA is that it is not an officially recognized metric in accounting, and its calculation can vary from company to company.
What is EBITDA?
EBITDA stands for earnings that stay in the company before deducting interest, taxes, depreciation, and amortization costs. This profit parameter represents cash generated by the company’s operations after material, salary, and rent costs are paid.
EBITDA as a business result category shows a company’s ability to create cash flows from regular operations and the consequent ability to pay off debts to the company’s creditors. Hence, it shows the company’s ability to create new value for the owners.
Why EBITDA Is So Important
The EBITDA is important because it measures a company’s operating profitability since it shows the percentage of results at the EBITDA level (profit before interest, taxes, and depreciation) in relation to the company’s operating income.
By calculating it, we can see how much of the gross revenue stays in the company after all regular costs/expenses of the business (e.g., material costs, salary costs, etc.) are paid!
Business entities with a higher value of EBITDA margin than the competition have a better cost structure; that is, they retain a larger part of the income after covering business expenses, which gives them an advantage over other companies in the same industry.
How to Calculate EBITDA
To get a better insight into the company’s operations over time and its profitability, it can be helpful to calculate the EBITDA quarterly.
By calculating it for a certain period, businesses can analyze the causes of why this margin started declining and make quick changes to stay competitive in the market.
Also, the EBITDA margin is usually higher in specific industries (e.g. oil and gas, railroad, mining, telecom, and semiconductors). Therefore, it is appropriate to compare it with the average of the company’s industry!
Formula
Two main formulas are used to calculate this metric:
- EBITDA = Net Income + Taxes + Interest Expense + Depreciation & Amortization
- EBITDA = Operating Income + Depreciation & Amortization
Which Metrics Are Included When We Calculate EBITDA
Net income
Net income is the amount a business makes after deducting costs, taxes, and allowances. It’s the amount of income the company has left after paying off its dues like employee payroll, rent, bills, and operational costs.
Taxes
Taxes are mandatory contributions imposed on businesses by a governing entity. Taxes fund government activities, including services such as roads and schools or programs such as Social Security.
Interest expense
An interest expense is a cost incurred by a business for borrowed funds. So it falls in a non-operating expense category.
Depreciation
Depreciation is the cost of an asset that has been used up for a single period. The period of time considered is often a year.
Amortization
Amortization is an accounting technique used to periodically lower the value of a loan or an asset over a period.
Operating income
Operating income is a company’s revenue after all expenses of operation and depreciation are subtracted from the revenue.
Examples of EBITDA Margin Calculation
Example 1
The net income of a new and rising apparel company is $50,000, and the taxes the company has to pay is $4,000. The interest expenses, depreciation, and amortization add up to $10,000.
All of the mentioned values are for the first year of business of the company.
Here is how the earnings before interest, taxes, depreciation, and amortization are calculated for this particular apparel company:
- $50,000 + $4,000 + $10,000 = $64,000
Example 2
A company that produces sustainable food packaging material that’s biodegradable makes a net income of $300,000. They had to pay $60,000 in taxes; the interest expenses were $20,000. Also, they spend $9,000 on depreciation and $8,000 on amortization-related costs.
The EBITDA calculation goes:
- $300,000 + $60,000 + $20,000 + $9,000 + $8,000 = $397,000
Example 3
A company that transports fresh crops across the country from the farmlands to super marks made a net income of $3 Million in a particular year.
The company had to pay $1.4 Million in taxes the same year, and their interest expenses were $0.5 Million. The depreciation of their vehicles and other machines was $0.3 Million, and they had to bear $0.3 Million in amortization.
Here’s how the crop transport company’s EBITDA is calculated for the year in question:
- $3 Million + $1.4 Million + $0.5 Million + $0.3 Million + $0.3 Million = $5.5 Million
Disadvantages of EBITDA
The main disadvantage of EBITDA is that it is not an officially recognized metric in accounting, and its calculation can vary from one company to another.
Companies like to put forth this metric instead of the net profit margin because the EBITDA value is higher, so they look more successful.
It is good to know that if a company doesn’t report its EBITDA, that can indicate that this business has extensive burrowing and rising capital and development costs.
This metric assumes that profitability is only a product of sales and operations. So it can be misleading, especially if the company promotes EBITA over net profit.
What is the EBITDA margin?
The EBITDA margin is a metric that measures a company’s operating profit as a percentage of its revenue. By calculating it, the company can know its actual performance compared to other businesses operating in the same industry.
The higher a company’s EBITDA margin, its operating costs are lower, so and profits of these types of companies are higher!
Margin Formula
The formula to calculate the EBITDA margin is:
EBITDA margin = ( net income + taxes + interest expense + depreciation + amortization) / total revenue
EBITDA margin = EBITDA / total revenue
This metric focuses on the essential operational profitability and cash flow. Some companies tend to draw attention to this metric to draw attention away from their debt to create the perception that their performance is better than it actually is.
How to Calculate EBITDA Margin (Examples)
Example 1
An electronic home company that produces items like toasters, ovens, and microwaves has a net income of $80,000 for a particular quarter.
In the same quarter, they had to pay $8,000 in taxes and $5,000 in interest expenses.
The company faced $9,000 in depreciation due to some of their stock going out of trend and additionally faced $5,000 in amortization. The total revenue of the home electronics company is $490,000.
This is how the EBITDA margin of the company is calculated for the quarter in concern:
= ( $80,000 + $8,000 + $5,000 + $9,000 + $5,000)/ $490,000 *100%
= 21.8%
The EBITDA margin of the home electronics company for the particular quarter is 21.8%!
Example 2
Digital marketing company ‘X’ specializes in creating trending TikTok videos for clients. With the rise of TikTok marketing in the world, the company has been making a high income.
They made $5 Million in a particular six months. In these six months, they also paid $1 Million in taxes and $0.8 Million in interest expenses.
The company faced a depreciation of $0.3 Million and an amortization of $0.8 Million. The company’s total revenue in those six months was 40 Million dollars.
Here’s how the EBITDA margin of this marketing company calculation goes:
= ( $5 Million + $1 Million + $0.8 Million + $0.3 Million + $0.8 Million) / $40 Million *100%
= 19.75%
The EBITDA margin for this marketing company is 19.75%!
Summary
When analyzing the profitability of some company or industry, it is always better to investigate how much a particular system delivers profit margins.
The profit margin percentage can give better and more accurate insights because EBITDA and its margins don’t cover all expenses that the owner and its business will face.