As a start-up, it can be so hard to highlight your value to investors. Without a track record of returns, it could be that your non-cash assets cannot be liquified and that debts and liabilities are holding you back.
But companies like AT&T, Apple, and General Electric were able to each receive funding after going into millions, if not billions, of debt.
So how did they make it happen? More importantly, how can you?
The EBITDA margin could be the perfect metric for showing off the potential of your business. It recognises that not all companies are liability-free but that debt shouldn’t hold you back. When combined with the context of your other financial data, a good EBITDA margin is a strong motivator for investors.
What Does EBITDA Stand For?
EBITDA stands for ‘earnings before tax, interest, depreciation, and amortization.’ It allows businesses to provide a screenshot of their financial performance and operating revenues. Companies can use their EBITDA margin to measure profitability and expected cash flow.
Let’s break down EBITDA.
Earnings
Earnings refer to your net income, aka the company’s total revenue over the course of the accounting period. Earnings may come from direct sales, along with income from channel partners and other standard income-generating business expenses.
In the case of EBITDA, earnings refer to operating revenue derived from the core sales. It does not refer to revenue earned by dividends, royalties, or other secondary sources of income. Thus, earnings before interest, taxes, depreciation, and amortization look solely at your operational revenue.
Earnings are calculated by subtracting operating expenses from total revenue.
Interest and Tax
Interest and taxes refer to the company’s financial expenses through the repayment of loans, funding, and corporation tax.
When measuring one company’s performance against another, it’s important to remove differences in the company structure and tax situation. By focusing solely on earnings before interest and taxes, analysts can compare how well a company will generate money from its working capital.
EBIT, while useful, is not a Generally Accepted Accounting Principle (GAAP) so investors and analysts will combine this factor with others as part of an overall financial report. Typically, the costs associated with interest or taxes are not deducted. By removing these factors, EBITDA becomes synonymous with operating profit.
Depreciation and Amortization
Depreciation refers to the reduction in the value of an asset over time. Think about yourself driving your brand new car away from the tarmac – it loses approximately 30% value within the first year. This depreciation is most commonly reported as a percentage.
Leaving out depreciation might distort the results for businesses with a large proportion of fixed assets. For example, machinery is likely to depreciate over time, reducing its value and becoming a cost to the business.
Amortization is defined as the spread of payments over time, which can be applied to tangible assets such as loans or intangible assets such as a patent. It is calculated similarly to depreciation, in accordance with GAAP.
Depreciation and amortization are important as each metric can be expensed every year. In the case of EBITDA, the margin is calculated with both depreciation and amortization added back in. This indicates the overall profitability rather than profit after expenses.
Why Use EBITDA?
As mentioned, EBITDA is not a universally recognised accounting measure through GAAP. So why use it?
Investors can use EBITDA to compare companies in the same industry. The metric helps to measure the performance of a company and its potential growth through its current cash flow. For example, a negative EBITDA indicates poor cash flow.
A company’s EBITDA is a direct measure of its financial health. When you remove factors like tax, depreciation, amortization, and interest, you reveal the long-term potential for growth.
If you take into account these factors when analysing the company’s overall financials, it’s difficult to compare across various tax situations and funding scenarios. How will an investor know which company has more potential for returns? So, EBITDA excludes these factors to mitigate the effects of non-operating cash and debt.
However, EBITDA is sometimes used to mislead. Since the metric does not provide a full picture, companies with high debt or expenses can get away with inflating their EBITDA margin and showing an enhanced financial performance. This is something that investors need to be wary of before committing funds to a business.
The other hindrance associated with EBITDA is that it varies greatly across different industries. Therefore, EBITDA is not the be-all-end-all of economic reporting and should be provided in context.
Calculate Your EBITDA
When calculating EBITDA, accountants and business owners will start at the bottom of an income statement and may have to refer to a cash flow statement to find depreciation and amortization.
Remember, you are adding back the expenses that were previously removed to calculate net income. Here is an example:
Revenue: $100,000 (cost of goods sold: $20,000)
Gross Profit: $80,000 (operating expenses: $10,000)
Operating Profit: $70,000 (interest expenses: $7,000)
Earnings before Taxes: $63,000 (tax expenses: $13,000)
Net Income: $50,000
Here’s how to calculate EBITDA for your business:
Net Income + Interest + Taxes + Depreciation + Amortization
Using the example above, let’s say the company accounts for $6,000 depreciation and amortization within their $10,000 operating expenses:
$50,000 (Net Income)+ $7,000 (interest) + $13,000 (taxes) + $6,000 (depreciation & amortization)
EBITDA = $76,000
EBITDA margin formula
EBITDA margins measure how much the operating expenses are removing a company’s profit. It’s a profit margin that shows the operating profit as a percentage of total revenue. The higher the EBITDA margin, the less of a risk for an investor.
To calculate the EBITDA margin:
EBITDA / total revenue
Using the example above: $76,000 / $100,000 = 76% (this calculation is purely demonstrational and not realistic of the market).
What is a Good EBITDA Margin?
A “good” EBITDA margin is largely dependent on the industry. But the average EBITDA margin for the S&P 500 in the first quarter of 2021 stood at 15.68%. Looking closer into individual companies, the EBITDA margin of Coca-Cola during the fourth quarter of 2020 stood at 9.83%.
To find out if your EBITDA margin is any good, it’s worthwhile to calculate the profitability of your competitors. Most (if not all) of the information required should be found within the published financial data.
So, will you be using the EBITDA margin to become the next AT&T, Apple, or General Electric? We hope you found the value in this article and share your insights on your way to the top!
