Investors and stakeholders use a broad range of calculations to evaluate companies. Some are included in the financial statement, but it makes sense to think outside the box to fairly assess a company’s performance and earning potential in other instances.

One way analysts do this is using earnings before interest, taxes, depreciation, and amortization (EBITDA), and the EBITDA margin. This calculation directly compares what businesses make because it excludes costs that may confuse how effectively a company is functioning.

What is the EBITDA margin?

EBITDA is a financial performance indicator that can be used instead of net income in some situations. EBITDA, as a contrast to net income, excludes the cost of capital investments such as property, plant, and equipment.

EBITDA = Operating Income (EBIT) + Depreciation + Amortization

The EBITDA margin quantifies earnings before interest, taxes, depreciation, and amortization as a percentage of revenue as a profitability ratio. The first step to calculate EBITDA is to gather the earnings before interest and tax (EBIT) from the income statement, then add back the depreciation and amortization expenses.

EBITDA Margin =  EBITDA / Total Revenue

Cost of goods and sales general and administrative costs are included in the "profits" portion of the EBITDA margin, but depreciation and amortization are not. Depreciation and amortization, respectively, are the reduction in the value of things over time and the spreading out of loan payments.

By excluding expenses that may disguise how a firm is objectively operating, the EBITDA margin allows for a clear comparison between organizations in terms of what they make. This is especially valuable to investors evaluating the earning potential of a newer company.

However, the EBITDA margin must be used carefully and under the correct circumstances because it is a little more complex. When used correctly, it’s an incredibly valuable calculation for analysts, investors, and stakeholders.

How do you use EBITDA margin?

EBITDA is not a GAAP measurement, but it’s still helpful from a comparison perspective when considered as part of a well-rounded analysis of all financial statements.

However, EBITDA alone may not make sense as a way to compare two companies. That’s why the EBITDA margin is useful. Essentially, the EBITDA margin shows the cash profit margin a company makes in a year. This makes it possible to compare two companies that may be in different phases of maturity.

If you compare profit alone between a startup and a company that has been around for five years, the older company will likely have more profit. Using the EBITDA margin makes it easier to compare earning potential, which is what investors are generally looking for.

The pros and cons of EBITDA margin

The EBITDA margin is often included in financial analysis because it provides an excellent comparison benchmark for companies in similar industries. If two companies appear very similar and produce a similar product, but one has a higher EBITDA margin, that company is probably the smarter investment. EBITDA margins are frequently cited in mergers and acquisitions conversations. A low EBITDA margin suggests that a company is experiencing both profitability and cash-flow concerns. The presence of a high EBITDA margin indicates that the company's earnings are stable.

However, some people are skeptical of EBITDA margin as a reliable indicator of a company’s earning potential. There are valid concerns about not including debt when evaluating the success of a company. In fact, companies with high debt may strategically use EBITDA to avoid discussing the topic.

A positive EBITDA alone does not prove that a company is operating responsibly or performing well. Without seeing changes in working capital, which EBITDA does not highlight, it’s hard to know how a company is doing. EBITDA also doesn’t take capital expenditures into account.

Capital expenditures can show the investments that a company is putting back into itself to fuel growth. Additionally, because it’s not a GAAP measurement, EBITDA calculations may not be consistent. It’s important to ask how EBITDA and EBITDA margins were calculated.

As a rule of thumb, the EBITDA margin should always be evaluated as part of the entire financial statement, not in isolation. If a company has high debt, EBITDA margin should not be used as a basis of comparison. Companies with high-interest payments are better candidates for this calculation.

EBITDA gets down to brass tacks

The EBITDA margin is a profitability statistic that measures earnings before interest, taxes, depreciation, and amortization as a proportion of revenue. The EBITDA margin is a non-GAAP metric that allows for a straightforward comparison between companies regarding what they make by removing expenses that may obscure how a firm is really running.

At the end of the day, it’s up to the finance experts to determine how to assess a company’s progress or compare potential investments. The EBITDA margin may be one helpful tool for doing so, but it’s not appropriate in all situations. This is just one example of the important decisions that financial analysts make that directly impact the company’s trajectory.