The EBITDA margin is considered to be a good indicator of a company’s financial condition because it evaluates a company’s performance without needing to take into account financial decisions, accounting decisions or various tax environments.
The EBITDA margin measures a company’s earnings before interest, tax, depreciation, and amortization as a percentage of the company’s total revenue.
EBITDA margin = (earnings before interest and tax + depreciation + amortization) / total revenue
Because EBITDA is calculated before any interest, taxes, depreciation, and amortization, the EBITDA margin measures how much cash profit a company made in a given year. A company’s cash profit margin is a more effective indicator than its net profit margin because it minimizes the non-operating and unique effects of depreciation recognition, amortization recognition, and tax laws.
Although the EBITDA margin is a good indicator of a company’s financial circumstances, it has a few drawbacks. EBITDA is not regulated by generally accepted accounting principles (GAAP), so it is not normally calculated by companies that report their financial statements under GAAP.
The EBITDA margin is an ineffective indicator of financial performance for companies with high levels of debt or for companies that consistently purchase expensive equipment for their operations. If a company has a low net income, it can also use the EBITDA margin as a way to inflate its financial performance. This is because a company’s EBITDA margin is almost always higher than its profit margin.
Other financial ratios, such as operating margin or profit margin, should be used concurrently with the EBITDA margin when evaluating the performance of a company.