If you are someone who keeps mixing up the operating margins with the EBITDA margins, you just have to remember one thing: The EBITDA is obtained by removing the cost related to depreciation and amortisation from the operating margin.
Conversely, if you’re a beginner, a company's operating profits and EBITDA are key financial parameters, just like the company’s revenues and profits. Even as a beginner, you understand the importance of metrics like the company’s revenue and profits. “Operating profits” and “EBITDA” may seem convoluted compared to the revenue and profit metrics, but they are equally important parameters.
If you wish to analyse a company’s financial health and profit-generating ability holistically, you must learn to look beyond its revenues and profits. So, let’s uncover these metrics, distinguish them, and understand their importance.
What Is The Importance of Operating Revenues and Operating Expenses?
To understand the concept of operating profit margins and EBITDA margins, we first need to know what a company’s operating revenue and expenses entail.
Operating Revenue
A company may generate revenue through various sources: the sale of its productS, the sale of its subsidiarIES , investing activities, etc. However, the primary revenue source—that investors are concerned about—is the sale of its product and services. To put it another way, investors are mainly interested in operating revenues and less interested in non-operating revenues.
That is because:
- The operating revenue tells you about the revenue-generation ability of the core business.
- Non-operating revenues can be a one-off, which may skew the bottom line, leading to inflated or depressed earnings.
Let’s understand how: Assume a company makes a loss of Rs.-10 Cr from its core operations but sells its subsidiary and generates other income of Rs.25Cr. In this case, the company will record a net income of Rs.15Cr. An investor who looks only at the—top line and bottom line—will not see the real picture here.
Operating Expenses
Likewise, when it comes to expenses, investors are primarily concerned with operating expenses. Again, operating expenses compromise those expenses the company incurs to run its day-to-day operations to produce its product or services; for example, the cost of raw materials, employee wages, machinery costs , advertising expenses, etc. It excludes other expenses, interest costs, and taxes.
What Are Operating Profit Margins?
You probably deduced this by now: The operating profits or incomes of the company are obtained by subtracting the company’s expenses from the operating revenue. When you divide this operating income by the company’s overall revenue and multiply it by 100, you get the operating profit margin.
Calculation: Operating Profit Margin= Operating Profit/Revenue*100
Investors use this metric to turn revenue into profits after accounting for opening expenses. You can also define it as the percentage of revenue left over after paying all the day-to-day operating expenses. As mentioned before, these operating expenses exclude costs like interest costs, tax expenses, profit and loss from investments, etc. Hence, the operating profit margin is also referred to as the earnings before interest, and taxes or EBIT margin.
What Is EBITDA Margin?
EBIT or operating profits, account for depreciation and amortisation costs . Remove these two costs, and you get EBITDA, which stands for—Earnings Before Interest, Taxes, Depreciation, and Amortisation.
So, EBITDA = EBIT (Operating Income) + Depreciation + Amortisation
The EBITDA margin is obtained by dividing the company’s EBITDA by its revenue and multiplying that by 100.
Calculation: EBITDA Margin = EBITDA/Revenue*100
But why create another financial metric (EBITDA) by subtracting operating expenses such as depreciation and amortisation from operating income?
Operating Margin Vs. EBITDA Margin
EBIT includes depreciation and amortisation cost; EBITDA doesn’t. Depreciation and amortisation are accounting methods of allocating the fixed cost of a fixed asset—the former is for tangible assets and the latter for intangible assets—over its useful life instead of accounting for the cost all at once when it’s purchased. Some investors believe that EBITDA or EBITDA margins give a more accurate picture of the company’s real operating performance and profit-generating abilities.
Example
Assume there are two capital-intensive businesses, let’s say manufacturing businesses, since the depreciation numbers are hefty in such businesses. Both companies, A and B, have similar operating profit margins. Company A undertakes a capital expansion project, buys equipment, and sets up new manufacturing plants; B does nothing of this sort.
Now, Company A’s operating profit margins will take a hit due to the capital expansion project due to the following :
- Higher depreciation expenses due to fixed asset addition
- The added plants can’t contribute revenue from day one.
The high depreciation depresses the bottom line and the operating profit margins to a large degree. So, an investor who only looks at operating profits will likely ignore Company A. They will believe Company B is superior; when, in fact, once Company A’s new plants start operating, the operating margins will become more or less similar again since company A is also generating higher revenues post the added capacity utilisation.
However, the EBITDA throughout this period would be unaffected, assuming every other factor remained the same. Gain insights into short-term trading strategies and how to use them to make profits in the market.
Conclusion
- Both the operating profit margins and the EBITDA are key financial metrics to evaluate the company’s financial health.
- The major difference between operating margin and EBITDA margin is that the former accounts for depreciation and amortisation costs, while the latter doesn’t.
- You can obtain the EBITDA by removing depreciation and amortisation costs from the operating profits (EBIT).
