Analyzing the finances and profitability of your company can be done in a variety of ways using different key metrics, including your EBITDA margin. Keeping track of these metrics can help you assess your growth, and make sure your business is in line with your industry and your competitors.
In this post, we’ll be taking a look at how to calculate your EBITDA margin and how this metric can give you valuable insights into the health of your business.
What is EBITDA? (definition and meaning)
EBITDA definition
EBITDA is defined as a company’s Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) are subtracted.
EBITDA meaning
The EBITDA definition above provides a clear explanation of what EBITDA is, but it lacks clarity when it comes to understanding what it means, how it’s used, and why it is important. EBITDA is a profitability metric used to measure a company’s overall financial performance and is typically used as an alternative to other standard measurements of profitability such as net income.
EBITDAis a widely used metric that has become a popular means of measuring profitability due to its ability to strip out expenses that might obscure how the company is truly performing, and therefore proponents of EBITDA argue it provides a much clearer reflection of operations than other profitability metrics.
What is EBITDA margin?
EBITDA margin is the profitability ratio measuring EBITDA to Revenue. EBITDA margin takes the metric one step further and provides additional insights by calculating the percentage of EBITDA to revenue. This percentage indicates how much of a company’s operating expenses are eating into profits, with a higher EBITDA margin indicating a more financially stable company with lower risk.
How to calculate EBITDA margin
The most common way to calculate your EBITDA margin is by starting with your net income, and then adding back in the figures for any interest you’re incurring, plus taxes, depreciation, and amortization.
The basic EBITDA formula is:
EBITDA = Net income + interest expenses + tax + depreciation + amortization
That said, EBITDA margin is usually expressed as a percentage. The EBITDA margin formula is:
EBITDA / total revenue
To see how EBITDA margins help compare the profitability of similar companies, let’s take a look at two startups selling the same product. Startup A is funded by debt and incurs interest payments, while Startup B is funded with equity.
The two income statements would look like this:
Startup A
Revenue $500,000 Amount of subscriptions sold $200,000 Interest ($180,000 loan at 10%) $18,000 Depreciation of assets $1,000 Income (before tax) $281,000 Net income (at 30% tax rate) $196,700 EBITDA $300,000
Startup B
Revenue $500,000 Amount of subscriptions sold $200,000 Interest expenses incurred $0 Depreciation $1,000 Income (before tax) $299,000 Net income (at 30% tax rate) $209,300 EBITDA $300,000
As Startup A is paying interest on their debt, it looks like they’re less profitable on the income statement. By applying the EBITDA margin formula, each of the startups ends up with the same margin.
So while Startup B looks to have a higher income and would be a better bet for an investor to buy when they’re carrying out a valuation, both companies are in fact on an equal footing as far as profitability. It’s only the interest expenses skewing the figures against Startup A.
What is a good EBITDA margin percentage?
A high EBITDA percentage means your company has less operating expenses, and higher earnings, which shows that you can pay your operating costs and still have a decent amount of revenue left over.
For the startup example above, both would have a 60% EBITDA margin ($300,000 / $500,000). A “good” EBITDA margin varies by industry, but a 60% margin in most industries would be a good sign. If those margins were, say, 10%, it would indicate that the startups had profitability as well as cash flow problems.
It’s helpful to calculate and compare your company’s EBITDA margins to see if they’re increasing, decreasing, or remaining relatively stable over time.
What does EBITDA margin mean for your business?
Your EBITDA margin will most likely be looked at if you’re planning to get investors on board, or if you’re looking to get acquired by a larger company.
This is because EBITDA margin is a measure of how well your company is able to generate a profit – without taking into account variables such as depreciating assets, taxes, and any costs associated with financing that you may be incurring. EBITDA margins give investors a clearer view on the health of your core operations. It strips away the factors that can have an effect on your operational profitability, so that investors can compare your company against similar businesses.
Any interest payments can impact your company profits. If investors were comparing you directly with a competitor that has either no debt or better interest rates, your company will look like a poor bet in comparison, even though your overall revenue might be the same. If you’re selling your company, it will most likely be sold debt free – so in terms of your overall company operations, any interest payments you’re making now aren’t relevant to a prospective buyer.
By taking taxes out of the equation, investors can compare you with other companies that might be in different locations or paying different tax rates for other reasons.
Similarly, depreciation and amortization don’t have any bearing on your company’s profitability. They are merely paper expenses that take into account the age and amount of your tangible equipment. If your business needs a lot more equipment to run its operations from day to day, taking depreciation and amortization into account would put you at a disadvantage over your competitors who run leaner companies. By removing these elements from your calculations, it gives you an even footing when comparing your company with similar businesses.
Despite its usefulness as a comparative metric, some companies manipulate this data to make their companies look more profitable. EBITDA margins don’t take debt into account, so companies that have a large amount of debt (and interest payments to match) shouldn’t tout this as their sole method of calculating their efficiency.
As with all metrics, it’s good to have a variety of different methods of calculations to give clarity to your company’s health.
In summary
The EBITDA margin is a simple metric that can be calculated from your company’s income statement to give you an overview of your company’s financial health. If you’re comparing your company against competitors or industry averages, it’s a handy metric that you can use to get a clearer picture of your operating performance.
It’s also likely to be a metric that investors use when deciding on whether to fund or acquire your company, so it’s important to familiarize yourself with this margin and what it means for your overall profitability.
Further reading:
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