A company’s profitability can be analyzed using multiple financial metrics, including EBITDA margin. Tracking EBITDA margin over time and comparing it to both industry averages and similar competitors helps assess the health of a business and determine future strategies.
Before we show you how to calculate EBITDA margin and how to interpret it, we’ll define EBITDA, discuss its importance, and clarify how EBITDA margin compares to other profitability measures.
What is EBITDA?
EBITDA definition
EBITDA is an abbreviation for Earnings Before Interest, Taxes, Depreciation, and Amortization. A measure of a company’s operational profitability, EBITDA is a good gauge of financial performance and is typically used as an alternative to other standard measurements of profitability, such as net income.
Why is EBITDA important?
EBITDA has become a popular profitability metric because it strips out expenses that can obscure how a company is truly performing — proponents of EBITDA argue it provides a much clearer reflection of operations than other metrics. VCs and investors frequently use EBITDA to evaluate potential growth capital investments, determine company valuations, and guide business acquisitions.
In most cases, calculating EBITDA requires only information from a company’s income or cash flow statement, so it's a fairly simple and straightforward metric to analyze.
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What is EBITDA margin?
EBITDA a profitability figure in dollars. EBITDA margin takes the analysis one step further and provides additional insights with a ratio of EBITDA to revenue, which is typically expressed as a percentage. This percentage indicates how much of a company’s operating expenses are eating into profits.
EBITDA vs. gross margin
While gross margin and EBITDA both measure a company's profitability, they have seemingly subtle but distinct differences.
Gross margin shows the percent of revenue a company retains after incurring direct costs from core business activities. A higher gross profit margin indicates a higher degree of profitability, but excludes a number of operating costs not accounted for in your cost of goods sold (COGS).
EBITDA margin lets you see full operational profitability, taking into account expenses necessary to run the day-to-day business, only eliminating the impact of financing and accounting decisions. This is generally a more useful metric to compare against similar businesses and industry benchmarks.
How to calculate EBITDA margin
The most common way to calculate your EBITDA margin is to start with your net income, and then add back in any interest you’re incurring, plus taxes, depreciation, and amortization.
The basic EBITDA formula is:
EBITDA = Net income + interest expenses + tax + depreciation + amortization
EBITDA margin is usually expressed as a percentage.
The EBITDA margin formula is:
EBITDA margin = EBITDA / total revenue X 100
To see how EBITDA margins make it easier to compare the profitability of similar companies, let’s take a look at two startups selling the same product.
Example
Startup A is funded by debt and makes monthly interest payments, while Startup B is funded with equity. The two income statements look like this:
Income Statement for 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 |
Income Statement of 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 |
Since Startup A is paying interest on their debt, it looks like they’re less profitable based on net income, alone. The EBITDA margin calculation for each of the startups, however, ends up the same.
So, while Startup B appears to be making a bigger profit and looks like it may be more valuable to investors, both companies are in fact on equal footing as far as profitability goes. It’s only the interest expenses that make Startup A seem like a potentially bad bet.
Interpreting EBITDA margin
A company with a high EBITDA percentage has fewer operating expenses and higher earnings, which shows it can pay its operating costs and still have a decent amount of revenue left over. Generally, a higher EBITDA margin suggests a company is low-risk and financially stable.
It’s helpful to calculate and compare your company’s EBITDA margin to see if it's increasing, decreasing, or remaining relatively stable over time. EBITDA margins become increasingly important and scrutinized when your business is raising money from new investors or looking to sell.
EBITDA margins provide a clearer view of operational health and profitability by stripping away the factors that don’t affect day-to-day business. Ultimately, removing certain elements from profitability calculations enables apples-to-apples comparisons between similar businesses.
Let’s break down why it’s helpful to use a normalized measure of profitability that removes certain costs:
Interest payments do impact company profits; however, they can make a company look much worse in comparison to a competitor that has either no debt or better interest rates — especially if revenue is about the same. Businesses are usually sold without debt, so a prospective buyer isn’t concerned with the impact of interest payments on your company operations.
Taking taxes out of the equation makes it easier to compare companies that might be in different locations or paying different tax rates for other reasons.
Depreciation and amortization don’t have any bearing on a company’s profitability. They are merely paper expenses that take into account the age and amount of tangible equipment. If a business needs a lot more equipment to run its operations from day to day, taking depreciation and amortization into account would put it at a disadvantage to competitors who run leaner companies.
Despite its usefulness, some companies still manage to manipulate EBITDA to make their businesses look more profitable.
Also remember, EBITDA margins don’t take debt into account, so companies that have a significant amount of debt (and interest payments to match) shouldn’t rely on this as their sole measure of efficiency or scalability.
As with all business metrics, it’s wise to use a variety of calculations to derive insights about your company’s overall health and direction.