Analyzing a company’s finances and its profitability can be done in a number of ways through different metrics. EBITDA margin is one such metric that can give valuable insights into a business’s health. Keeping a close watch on these metrics can help investors to assess a company’s growth and the company itself can use it to check if its business is in line with the industry and competitors.
Here, we will discuss EBITDA margin in detail, including the concept of EBITDA, calculations, advantages and drawbacks of using EBITDA margin.
What is EBITDA?
EBITDA is short for earnings before interest, taxes, depreciation, and amortization.
EBITDA is a profitability metric that is used to measure a company’s financial performance. It is often used as an alternative to some of the standard profitability measurements, like net income.
It has become a popular means of profitability measurement since it strips out expenses that may conceal how a company is actually performing. It is believed to offer a far clearer reflection of company operations as compared to other profitability metrics.
What is EBITDA margin?
- Is a profitability ratio.
- It measures EBITDA to Revenue.
- Provides additional insights by taking a percentage of EBITDA to revenue.
- It indicates how much of a company’s operating expenses are reducing its profits.
A higher EBITDA margin indicates a financially stable company that carries lower risk.
How to calculate EBITDA?
The formula for measuring EBITDA is:
EBITDA = Net income + interest expenses + tax + depreciation + amortization
Suppose a company’s revenues are Rs. 75 lakhs.
Net income= Rs. 10 lakhs,
Depreciation expenses = Rs. 2 lakhs,
Amortisation expenses = Rs 1 lakh,
Taxes = Rs 1 lakh,
Thus EBITDA will be,
EBIDTA = 10 +(2+1+1) = Rs 14 lakhs
EBITDA margin can be derived by dividing EBIDTA by revenues.
EBITDA margin = 14/75 = 18.67%
How to interpret EBITDA margin
Here are the common interpretations of EBITDA margin results:
Financial strength and performance
With the EBITDA margin, we can gauge a company’s financial strength, specifically its revenue generating capacity. It tells us how much cash a company is able to generate vis-à-vis every Re.1 worth of revenue, excluding non-operational and external costs. It also tells how successful a company has been in its cost-cutting measures.
- A high EBITDA indicates a strong and efficient cash flow with low operational expenses.
Performance measurement against peers
EBITDA helps in drawing a comparison between two companies that are part of the same industry but with different market capitalisations.
Let’s take the example in the table below to understand how comparison can be drawn:
|Particulars||Company ABC||Company XYZ|
|Revenue (Rs. in lakhs)||7||70|
|EBITDA (Rs. in lakhs)||4||25|
From the above, we can see that Company ABC’s EBITDA is higher than Company XYZ. This, despite the revenues of the former being lower than the latter.
It tells us that Company ABC is comparatively better managed and has a cost-efficient approach as compared to Company XYZ.
Limitations of EBITDA margin
Here are some of the drawbacks of EBITDA margin:
Scope of unfair business practices
EBITDA can be used as a profitability measure by companies. However, since it is not mandated under GAAP, it may not be used at all times. Due to the absence of accounting regulations in this case, companies may resort to unfair practices and modify EBITDA to reflect a positive outlook for investors.
Inadequate measure of debt-reliant companies
EBITA is not a holistic measure to determine a company’s profitability, especially if it is using a significant amount of debt since it does not consider interest expense. It can therefore not be considered as a holistic metric for gauging the financial health of debt-heavy companies.
Companies that have heavy debt usage may also shift focus on EBITDA margin from net profit margin to falsely tempt investors towards investing.
Latest news on Zomato’s EBITDA play
In recent times, there have been concerns about certain tech startups using creative accounting methods to present a more favorable financial picture. For instance, Zomato, a food delivery and restaurant aggregator platform reported a positive adjusted EBITDA figure for the quarter ending in December 2020, despite significant losses in the past. This comes even as the company cut nearly 2,000 jobs in 2020, following the pandemic’s impact on its business.
Many startups use non-standard metrics such as adjusted EBITDA to report their financial performance, which does not accurately reflect their financial health. However, Zomato faced social media backlash for using adjusted metrics in its quarterly financial results for the quarter ending June 2021, despite a net loss of INR 356 crores ($48 million). This sparked concerns over the validity of using adjusted metrics and accusations of financial manipulation. In response, Zomato argued that adjusted metrics are an industry standard and that it had followed proper accounting standards. The incident highlights the need for startups to focus on transparent financial reporting and communicate effectively with stakeholders about their financial performance.
EBITDA margin can provide a useful view of a company’s profitability and enable easier comparisons among companies within an industry. However, it’s recommended to use additional metrics within an analysis to get a more holistic picture of a company’s true value.
Net margin is the ratio of net profit to total revenue. It includes income from other sources, interest expense, depreciation & amortisation, and taxes. As compared to EBITDA margin, Net margin provides a better assessment of companies that have substantial debt.
EBITDA margin is a better indicator of a company’s financial health and cash flow as compared to operating margin because the former does not consider extraneous expenses such as depreciation & amortisation, which may compromise the analysis.
Cost of revenue includes expenses that are directly related to revenue-generating operations. These are mostly variable expenses since they change with any changes in production. Some examples include freight cost, labour expenses, packaging cost, freight expenses, etc.
Analysts and investors often use EBITA (earnings before interest tax and amortization) and EBIT (earnings before interest and tax) as alternatives to EBITDA margin.
The EBITDA of a company has to be viewed in comparison to another similar company and it cannot be used as standalone. The higher the EBITDA of a company compared to another, the better its financial strength is considered to be.