EBITDA Margin – Definition, Calculation & Limitations

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.

Understanding 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?

EBITDA margin:

1. Is a profitability ratio.
2. It measures EBITDA to Revenue.
3. Provides additional insights by taking a percentage of EBITDA to revenue.
4. 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
EBITDA margin	57%	36%

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.

Conclusion

EBITDA Margin is a useful metric to analyse the performance of a stock but it comes with its own set of advantages and limitations. So, it is always good to analyse a stock on multiple financial metrics that can give you a rounded view rather than base it on a single financial ratio.

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