When looking for a company to invest in, you need to assess the financial health of the company. Even if you are not a professional evaluator, you can do your research to determine which companies have the best chances of giving you the profits you desire.
Many can help you gauge the profit-making capabilities of the companies in which you may want to invest. However, two of the most used indicators are the ‘operating margin’ and ‘EBITDA margin’- Earnings before interest, tax, depreciation, & amortisation.
While both indicators are essential, they have specific differences. Let’s take a look at what both these indicators mean, how are they calculated, their uses, and then how they differ.
What is EBITDA?
An EBITDA margin allows the investor to understand the operational profitability as well as the cash flow of the company. It can be used to evaluate a range of companies regardless of their size, structure, tax obligations, or depreciation.
An EBITDA margin is used to determine the efficiency and performance of the company, along with its earning potential without focusing on aspects like taxes or debt financing.
The formula for calculating the EBITDA margin is EBITDA/Total revenue *100.
For example, if company ABC shows an Annual Revenue of Rs. 10, 00,000, and EBITDA of Rs. 1,00, 000, its EBITDA margin is 10. The higher the EBITDA margin, the more operationally efficient the company is perceived to be. Some of the industries whose companies have the highest EBITDA margins include telecommunication, oil, railroads, tobacco, alcohol, and banking.
The EBITDA margin is a good indicator when you are exploring the potential of investing in a small or a big name in the same industry. Let’s say you have the option of investing in firm ABC, which has an annual revenue of Rs. 10,00,000 or firm PQR which registers an Annual Revenue of INR 30, 00, 000. The face value suggests that you invest in firm PQR because it has a significantly higher revenue. However, on calculating the EBITDA margin, you may find that firm ABC has an EBITDA margin of 30 percent. In contrast, firm PQR has it at a lower 15 percent, indicating a relatively lower operational efficiency.
While EBITDA margin is a helpful indicator to determine the financial performance of the company, it can be unhelpful and misleading in case of companies that have significantly high debts. Such debts need to be taken into account before concluding the financial health of the company.
What is Operating Margin?
An operating margin is a profitability ratio calculated by dividing the operating profit by the revenue, multiplied by 100. It is used to determine the profitability of the company based on its operations. Essentially, the operating profit margin is the revenue percentage that remains after subtracting the operating expenses.
Let’s take a look at the components of the formula to calculate the operating margin.
Operating profit or operating income, as the name suggests, is the profit left after the day-to-day expenses and cost of goods have been subtracted from the net sales. It takes into account only those variables that go into maintaining the operations of the company and avoids any extraneous variables.
The operational expenses will include salaries, wages, benefits to employees, fees paid to consultants, cost of raw material, administrative costs, advertising, and marketing costs, rent, utilities, insurance premiums, depreciation, amortisation. The expenses that are not included in this calculation are taxes paid, interest on debt, loss or profit from investments, or any other gains or losses that may have occurred that are not part of the company’s daily operations.
The formula for calculating operating profit/ operating income is Gross Profit – Operating Expenses – Depreciation – Amortisation.
The second component required to calculate the operating profit margin is ‘Revenue’ or ‘Net Sales’. It is the total income generated by the company by the sale of its products or services. ‘Gross Sales’ is different from ‘Net Sales’. The ‘net sales’ is arrived at by subtracting any sales discount or sales returns from the gross sales.
You can find the ‘revenue’ in the first line of the company’s income statement.
Thus, the formula to calculate the operating margin is:
Operating Profit/ Net Sales * 100.
The resulting percentage is the operating margin of the company.
The higher the operating margin, the more profits the company is earning from its operations.
EBITDA Margin vs Operating Margin:
While both are highly popular metrics to determine the profitability of a company, EBITDA and operating margin differ in significant ways which include:
1. EBITDA is used to determine the total potential earnings of the company, whereas the operating margin aims to identify how much profit can the company generate through its operations.
2. Under EBITDA, adjustments can be made in amortisation and depreciation, whereas, in the operating margin, it cannot be done.
3. EBITDA is not a measure under the Generally Accepted Accounting Principles (GAAP) which means it is not used for financial reporting, whereas operating margin is officially under GAAP. This can allow companies to announce the EBITDA metric year if it makes them look profitable, and discard it the next year if it doesn’t show the company in a good light.
However, as an investor, you can put more faith in companies that consistently state their EBITDA, and you can assess them based on the EBITDA’s and other indicators’ historical performance.
Both EBITDA Margin and Operating Margin have their uses and limitations. Take into account these two indicators and continue your research into the other determinants of a company’s profitability.
Once you have made your calculations and arrived at a decision, get in touch with a broker to make your investments, and secure your financial future.