Fundamental Analysis · Intermediate · 4 min
EBIT, EBITDA and margins
You can derive EBIT and EBITDA from an income statement, calculate gross, operating and net margins, and explain what EBITDA leaves out.
The biggest profit number
Company presentations often lead with one number: EBITDA. It is usually the largest profit figure on the slide, and many takeover prices are quoted as a multiple of it.
There is a reason it is the largest. It leaves out several real costs. This lesson shows how EBIT and EBITDA are built from the income statement, what margins tell you, and why careful investors treat EBITDA with some suspicion.
Adding costs back
The income statement runs from revenue down to net income. EBIT and EBITDA stop earlier on the way down, or, if you start from net income, add some costs back.
- EBIT stands for earnings before interest and taxes. It is close to operating profit: what the business earns from its operations, before the cost of its debt and before tax. It makes companies with different debt levels and tax rates easier to compare.
- EBITDA also leaves out depreciation and amortization. Depreciation spreads the cost of machines and buildings over the years they are used. Amortization does the same for intangible assets, such as purchased licenses or customer lists.
For the fictional bicycle maker:
Neither number is defined by official accounting standards. EBITDA is a non-GAAP measure. When a US company reports one publicly, SEC Regulation G requires it to show the most directly comparable official figure next to it, such as net income, and a reconciliation between the two.
A profit margin divides a profit by sales and shows how much of each dollar of sales remains:
- gross margin = gross profit ÷ sales,
- operating margin = operating profit (EBIT) ÷ sales,
- net margin = net income ÷ sales.
Cents per dollar of sales
The bicycle maker sold 500 million. Its margins:
- Gross margin 40%: after the materials and factory work, 40 cents of every dollar remain.
- EBITDA margin 20%: 100 million ÷ 500 million.
- Operating margin 16%: after staff, marketing and depreciation, 16 cents remain.
- Net margin 10%: after interest and tax, 10 cents are profit.
Margins become useful when compared. If the operating margin rises from 12% to 16% over three years, the company is keeping more of each sale. If a rival with the same products earns 8%, one of them is doing something different. Margins differ by industry too: supermarkets usually work with thin margins, software companies often with wide ones.
Common mistakes
- Treating EBITDA as cash. It ignores the money needed to replace equipment, and also changes in working capital. In his 2000 letter to shareholders, Warren Buffett criticized EBITDA for ignoring capital expenditures.
- Comparing EBITDA across very different businesses. For a capital-heavy company, depreciation is a large and real cost. For a consulting firm it barely matters.
- Accepting "adjusted" figures without checking. Companies choose which costs to adjust. Read the reconciliation.
- Looking at one year's margin only. The trend over several years says more.
The takeaway
EBIT is profit before interest and tax, EBITDA also before depreciation. Margins show how much of each dollar of sales stays as profit.
Check yourself
Quick quiz
4 questions. Instant feedback, nothing is saved.
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1Tap the line that is profit before interest and tax, but after depreciation.
Tap the chart.
EBIT, 80 million here, adds interest and tax back to net income. EBITDA also adds back depreciation and amortization.
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2Sales are 200 million and operating profit is 30 million. What is the operating margin?
Operating margin = operating profit ÷ sales = 30 ÷ 200 = 15%.
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3What is the main criticism of EBITDA?
Depreciation spreads the cost of past investment over time. Leaving it out makes capital-heavy businesses look more profitable.
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4What must a US company do when it reports EBITDA publicly?
EBITDA is a non-GAAP measure. SEC Regulation G requires the comparable GAAP figure and a reconciliation.
of 4 correct.