|
We looked at three main financial statements. We've taken a look at the different parts of an income statement and how to determine whether a company is profitable. We looked at the differences between assets, liabilities and shareholders' equity and where they can be found on a balance sheet. Using the cash flow statement, we can find out how much money a company makes from its main operations (or how much it spends on these operations), from its investing and financial activities.
In this section we will conduct a trial analysis financial statements.
However, now that we understand all these reports, how can we, as investors, use them? In this section we will conduct a sample analysis of financial statements. Such an analysis aims to make connections between different financial indicators more understandable to the investor (usually using special financial ratios). The ultimate goal of financial statement analysis is to understand the financial condition of a company and its prospects.
How to Use Financial Ratios
We have already touched on some of the coefficients earlier, but in this section we will take a closer look at the most important ones. Some ratios may be important in their own right, while others are completely useless when considered out of context. In most cases, financial ratios are most useful when compared to other identical ratios.
Ratios of an individual company are usually compared in two ways: the values of similar ratios for different periods and the values of similar ratios for different companies.
Individual company ratios are typically compared in two ways: similar ratios over different periods, and similar ratios across different companies (usually in the same industry). Comparing a company's performance over several periods is a great way to understand where the company is heading and determine its prospects. If certain indicators improve steadily, this may indicate an improvement in the company's financial condition. Conversely, if ratios deteriorate over time, this may indicate certain difficulties awaiting the company in the future.
It is also important to compare the company's ratios with similar ratios of other companies in the industry. A company's ratios may improve over time, but how do they compare to those of its competitors? If they make all the company's improvements look a little pale in comparison, then this may indicate that the company is not very well managed compared to other players in the industry.
The four most important groups of ratios are efficiency, liquidity, financial leverage and profitability.
The four most important groups of ratios are efficiency, liquidity, financial leverage and profitability. Below we will try to consider in detail some of the most important coefficients in each group.
Efficiency ratios
It doesn't matter what business a company is in - in order to make money, it must contribute to its assets. Efficiency ratios show how efficiently a company uses its assets, as well as how well it manages its liabilities.
Inventory turnover
This ratio shows how well a company manages its inventory. If their turnover is too low, it is likely that the company is overstocked or experiencing sales difficulties. Other than that equal conditions, the higher this indicator, the better.
Inventory turnover = Cost / (Average inventory)
Accounts receivable turnover
This ratio measures the effectiveness of the company's credit policy. If this ratio is too low, it may mean that the company is too liberal with its debtors, that it is giving out trade credit and payment deferments too generously, or that it is having difficulty collecting payment from its customers. All other things being equal, the higher this indicator, the better.
Accounts receivable turnover = Revenue / (Average accounts receivable)
Accounts payable turnover
This ratio uses a company's liabilities rather than its assets and its costs rather than its revenues in its calculations. This metric is quite important because it shows how well a company is doing at paying its own bills. A high value may be a signal that the company is not receiving favorable payment terms from its suppliers. All other things being equal, the lower this indicator, the better.
Accounts payable turnover = Cost / (Average accounts payable)
Asset turnover
Asset turnover is the most general indicator of a company's performance, which shows how effective the company's management is in using both the short-term and long-term assets of the company. All other things being equal, the higher this indicator, the better.
Asset turnover = Revenue / (Average asset size)
Liquidity ratios
In a nutshell, a company's liquidity is its ability to meet its short-term obligations. A company's liquidity is an important indicator of its financial health. Liquidity can be measured by several financial ratios.
Current liquidity
The current ratio is the most common test of liquidity. It indicates the company's ability to cover its short-term liabilities with its short-term assets. A current ratio greater than or equal to one indicates that current assets are sufficient to meet all of the firm's short-term liabilities. A current ratio of less than one indicates that the company has certain liquidity problems.
Current ratio = (Current assets) / (Current liabilities)
Instant liquidity
The instant liquidity ratio places more stringent requirements on the company. It excludes some current assets from the calculation, such as inventory and deferred expenses, since they may be very difficult to convert into cash within a reasonable period of time. As with the current ratio, a flash ratio above one means that the company does not have liquidity problems. The higher the value of this indicator, the easier for the company will get out of any unforeseen situations related to finances.
Quick Ratio = (Cash + Accounts Receivable + Short-Term Investments) / (Current Liabilities)
Cash liquidity
The cash liquidity ratio is the most demanding and conservative for assessing the financial condition of a company. It considers only a company's cash and its short-term investments when calculating the ability to pay its short-term liabilities. Higher values of this ratio indicate stronger financial health of the company.
Cash Ratio = (Cash + Short-Term Investments) / (Current Liabilities)
The concept of a company's financial leverage refers to the amount of debt that a company has on its balance sheet.
The concept of a company's financial leverage refers to the amount of debt that a company has on its balance sheet and is also another indicator of the company's financial health. In general, the more debt a company has, the riskier its stock is, since bondholders will have first claim on the company's assets if it goes bankrupt. In particularly severe cases of bankruptcy, shareholders may be left with nothing at all.
Debt/Equity
The debt-to-equity ratio shows the level of a company's financing from borrowed sources compared to the money allocated for the development of the company by its owners. A company that has a very high level of debt will have an extremely high debt/equity ratio. Companies with a low ratio, all other things being equal, are more attractive because they are less risky investments.
Debt/Equity = (Short-term liabilities + Long-term liabilities) / (Company's capital)
Interest Coverage
If the company is financed through borrowed money In the vast majority of cases, the company pays interest to bondholders. The interest coverage ratio shows the company's ability to pay interest on its debts from the income generated from the company's operating activities. A high coverage ratio is more favorable for the company, while a ratio of one means serious problems for the company.
Interest Coverage = (Operating Profit) / (Amount of Interest Payable)
Profitability ratios
How well does the company run its business? Are things going uphill or going downhill? Does she make money? How successful is it compared to its competitors? All these extremely important questions can be answered by analyzing profitability ratios.
Gross Margin
You may remember that gross profit is the difference between a company's revenue and how much its goods or services cost the company. Gross margin is the percentage of gross profit in each dollar of sales. The higher the gross margin, the greater the premium a company receives when selling its goods or services. However, it must be remembered that in different industries Gross margins can vary dramatically.
Gross Margin = (Gross Profit) / (Sales Revenue)
Operating margin
Operating margin shows how much a company makes or loses from its core business for every dollar of sales. This is a much more complete and accurate indicator of a company's performance than gross margin because it takes into account not only the cost of goods, but also other important operating costs that we discussed in , including marketing and sales costs.
Operating Margin = (Operating Profit or Loss) / (Sales Revenue)
Net profit margin
The net profit margin shows how much of the company's revenue remains after deducting all possible costs and payments, regardless of their nature. Although this indicator is very important, it contains a large amount of “noise”, both positively and negatively affecting the final indicator.
Net Profit Margin = (Net Profit or Loss) / (Sales Revenue)
Free Cash Flow Margin
In the about section, we looked at the concept of free cash flow and noted its importance to a company. Free cash flow margin measures a company's ability to generate cash per dollar of sales.
Free Cash Flow Margin = (Free Cash Flow) / (Sales Revenue)
Return on assets
Return on assets reflects a company's ability to convert its assets into profits. (This metric should not be confused with asset turnover, discussed earlier. Asset turnover measures how efficiently a company's assets generate revenue.)
Return on Assets = (Net Income + Tax Adjusted Interest Payments) / (Average Assets)
Please note that interest payments are added to net profit. This occurs because return on assets takes into account the company's profitability generated from all types of assets, including debt-financed assets. Therefore, when calculating this ratio, we add to earnings the amount paid to the company's debt holders.
The tax adjustment is necessary because income tax is levied on a company's profits calculated after interest payments have been made. In order to adjust interest payments, you need to do the following: determine the effective tax rate by dividing the amount of accrued income tax before tax, and then substitute the resulting rate into the following formula:
Interest payments adjusted for taxes = (1 − Effective tax rate) * (Actual interest payments)
Return on assets is usually expressed as a percentage and, other things being equal, the higher the value, the better.
Return on capital
Similar to return on assets, return on equity takes into account the return on shareholders' investment in the company's capital. It is also expressed as a percentage and, other things being equal, the higher its value, the better.
Return on equity = (Net profit) / (Average share capital)
Summing up
In this section we tried to put into practice what we previously discussed in the three previous sections. We examined financial ratios and also noted the importance of using them in a comparative context. We have listed various types of ratios including efficiency, liquidity, leverage and profitability ratios.
|
What additional information do profitability indicators provide?Profitability, profitability and profitability are relative values: they show the relationship between profit and any type of cost. They allow you to make reasoned management decisions to improve performance and bring companies out of the crisis. Management based on these indicators is facilitated by the presence of standard values (benchmarks), below which doing business is inappropriate. The most important indicators of this group are presented in table. 4.4.
Table 4.4
Profitability indicators
|
Indicators
|
Possible interpretation and comments
|
|
Return on sales (Return On Sales
, ROS)
|
Shows profit per monetary unit of sales. Depending on the type of profit involved in the formula, different types of profitability (types of margin) are distinguished, each of which allows one to clarify management decisions
|
|
Gross Margin (Gross Margin, GM)
|
Shows managers' ability to manage sales and production costs. Its decline indicates that costs are growing faster than sales. If CM
low, the firm is generally considered to have potential problems, and if it is low long time, then most likely the company will cease to exist. Some sources indicate that G.M.
should not be less than 25%
|
|
Operating margin (Operating Maigin, OM
)
|
Helps determine how selling and administrative expenses are controlled, e.g. how management works. High G.M.
at low OM
may indicate high administrative and commercial costs relative to the main production; an increase in the gap indicates ineffective management
|
|
Pre-tax margin (Pretax Matgin, PM)
|
Shows how financial policy is regulated or the tax base is “optimized”. A low indicator indicates low profitability of the business or “creative” accounting, the company’s avoidance of paying taxes
|
|
Net Margin (Net Maigin, NM)
|
This indicator largely depends on tax legislation. In some cases, “problem” companies belonging to the group of strategic (systemically important) companies may receive tax benefits in the form of deferred payments, tax holidays, etc. In some sources N.M.
And ROS
are considered as synonyms, i.e. ROS
calculated only on net profit
|
|
Return on assets (Return on Assets, ROA
)
|
Shows the ability of assets to generate income. When making calculations, the numerator of the fraction is usually substituted with the value of the profit received from all types of activities of the organization (pre-tax). Low value ROA
usually speaks of the need to increase the efficiency of use of property or to liquidate part of it. On ROA
The policy for reflecting assets in the balance sheet is affected: understating the balance sheet currency leads to an overstatement of the financial result.
The higher the share of high-risk assets, for example, overdue accounts receivable, the lower the “quality” of profit, the lower the possibility of its only virtual existence.
Index ROA
useful not only For
analysis of “your” enterprise, but also to assess the feasibility of mergers and acquisitions and other strategic alternatives
|
|
Profitability equity (Return on Equity, ROE)
|
Shows the return on investment of the owners of the enterprise. Typically compared to the performance of an alternative investment. Return on equity can be calculated not according to the balance sheet, but according to market valuation equity, which may more accurately reflect the situation of the owners of the problem company
|
|
Profitability of certain types of products
|
Indicators may be important when adjusting the range of products and services, but calculations require an accounting policy that allows you to correctly “allocate” costs to individual species products
|
In a number teaching aids It is proposed to use other profitability indicators: return on net assets ( RONA
), return on invested capital ( ROCE
), cash flow yield ( CFROI
) etc. However, their information value is close to the indicators presented in the table; they focus attention on special issues that may be important only in individual cases. At the same time, it should be taken into account that interpretation and decision-making based on a number of coefficients may be incorrect. For example, return on investment ( ROI, ROIC
) allows you to determine profitability for a period, and not for the entire life of the project: a project can be unprofitable at the beginning, and then bring high profits. For troubled companies use ROIC
as the main indicator threatens the abandonment of profitable projects or, conversely, underestimation of the “difficult period” when launching a project.
Example 4.3
Indicators of profitability of sales of JSC AvtoVAZ in 2006–2009 it. show negative dynamics (Fig. 4.7), but in the post-crisis period we can talk about their growth. A deeper analysis shows that during the crisis of 2008–2009. The gross margin remained low and positive, and the operating margin indicates that the company was deeply unprofitable.
Rice. 4.7.
Dynamics of gross and operating margins of OJSC AvtoVAZ for the period 2006–2012.
This indicates not only a decline in sales during the crisis: a significant gap between gross and operating margins may also indicate unreasonably high administrative and commercial expenses.
There is a small gap between the operating and pre-tax margins (Fig. 4.8) throughout the period under review, which is due to the insignificant amount of the company’s non-operating expenses. Interest expenses, which often make up the bulk of these expenses, are low due to the fact that most loans received are interest-free.
Gap between pre-tax and net margins 2006–2012 small (Fig. 4.9), which indicates insignificant income tax expenses.
This is explained by the fact that AvtoVAZ OJSC belongs to the group of strategic enterprises, and the state, in order to support the company, has exempted it from paying taxes several times over the past 20 years. Thus, in 2010, despite the profit received, the company had no tax payments due to the acceptance of the accumulated tax loss of 2008–2009. to reduce the tax base for income tax.
Rice. 4.8.
Dynamics of operating and pre-tax margins of OJSC AvtoVAZ for the period 2006–2012.
Rice. 4.9.
Dynamics of pre-tax and net margins of OJSC AvtoVAZ for the period 2006–2012.
An analysis of the return on assets in the pre-crisis period shows that, with the industry average of 14.8–15.6%, the return on assets of AvtoVAZ OJSC was only 4% (Fig. 4.10). During the crisis of 2008–2009. it was negative due to losses. Monitoring ROA
in 2010–2012 at first glance, it is encouraging: the indicator has a positive value and is growing: in 2012, the growth rate of profits was 4 times higher than the growth rate of assets, which contributed to the growth ROA
up to 27%. However, unfortunately, the basis for the profit growth was a purely non-cash accounting transaction: the profit growth was due to the recognition of income from the discounting of an interest-free loan (in fact, a government subsidy).
Rice. 4.10.
Dynamics of profitability of assets of OJSC AvtoVAZ for the period 2006–2012.
The dynamics of return on equity of OJSC AvtoVAZ (Fig. 4.11) largely repeats the dynamics of return on assets (see Fig. 4.10) and is explained by the same reasons: growth cannot be explained by successes in the company’s business processes.
Rice. 4.11.
Dynamics of return on equity of OJSC AvtoVAZ for the period 2006–2012.
|
Explanation of the indicator
Profitability of products sold based on sales profit (English equivalent - Operating Income Margin) is a profitability indicator that measures the amount of operating profit (gross profit minus other operating expenses) generated by each ruble of sales.
Operating profit margin measures the percentage of money remaining after subtracting cost of goods sold and other operating expenses from revenue. A higher operating profit margin also means less financial risk for the company and the ability to pay its fixed costs, such as interest obligations.
The indicator is calculated as the ratio of profit from sales to total sales.
Standard value:
Obviously, the higher the operating profit margin, the better company carries out its activities. Generally, businesses that show an increasing trend in operating profit margins also show improved overall cost management efficiency.
Rosselkhozbank considers these indicators to be normative:
Table 1. Standard value of the indicator, %
Source: Vasina N.V. Modeling the financial condition of agricultural organizations when assessing their creditworthiness: Monograph. Omsk: Publishing House NOU VPO OmGA, 2012. p. 49.
Directions for solving the problem of finding an indicator outside the standard limits
If the value of the indicator is lower than the standard or desired value, then it is advisable to look for opportunities to reduce operating costs, namely sales costs, management costs, costs of supporting the production process, and other operating costs. For example, such activities could be the use software, which will free up some of the labor resources, optimize the costs of maintaining the office, optimize the costs of Marketing communications etc.
Calculation formula:
Profitability of products sold based on sales profit = Sales profit / Revenue * 100%
Dynamics of the indicator in Russia
Rice. 1. Dynamics of the average operating margin in Russian Federation(excluding small companies)
Data Federal service state statistics
In the last few years, due to the difficult macroeconomic situation, there has been a decrease in the indicator compared to the period 2004-2008. At the end of 2015, each ruble of revenue generated 9.3 kopecks of profit from sales.
Calculation example:
Company OJSC "Web-Innovation-plus"
Unit of measurement: thousand rubles.
Profitability of products sold based on sales profit (2016) = 1100/3721*100% = 29.56%
Profitability of products sold based on sales profit (2015) = 1112/3841*100% = 28.95%
Despite the decrease in sales volume of the Web-Innovation-plus company in 2016, the company’s operating margin increased, which indicates more effective management of operating expenses in 2016. At the end of the study period, each ruble of sales allowed us to receive 29.56 kopecks in profit from sales Factors that increase operational efficiency include reducing the cost of products and services and optimizing business expenses.
Many people come across the concept of “margin,” but often do not fully understand what it means. We will try to correct the situation and answer the question of what margin is in simple words, and we’ll also look at what types there are and how to calculate it.
Margin concept
Margin (eng. margin - difference, advantage) is an absolute indicator that reflects how the business operates. Sometimes you can also find another name - gross profit. Its generalized concept shows what the difference is between any two indicators. For example, economic or financial.
Important! If you are in doubt about whether to write walrus or margin, then know that from a grammatical point of view you need to write it with the letter “a”.
This word is used in a variety of areas. It is necessary to distinguish what margin is in trading, on stock exchanges, in insurance companies and banking institutions.
Main types
This term is used in many areas of human activity - there are a large number of its varieties. Let's look at the most widely used ones.
Gross Profit Margin
Gross or gross margin is the percentage of total revenue remaining after variable costs. Such costs may be the purchase of raw materials for production, payment of wages to employees, spending money on marketing goods, etc. It characterizes general work enterprise, determines its net profit, and is also used to calculate other quantities.
Operating profit margin
Operating margin is the ratio of a company's operating profit to its income. It indicates the percentage of revenue that remains with the company after taking into account the cost of goods, as well as other related expenses.
Important! High indicators indicate good performance of the company. But be on the lookout because these numbers can be manipulated.
Net Profit Margin
Net margin is the ratio of a company's net profit to its revenue. It displays how many monetary units of profit the company receives from one monetary unit of revenue. After calculating it, it becomes clear how successfully the company copes with its expenses.
It should be noted that the value of the final indicator is influenced by the direction of the enterprise. For example, companies operating in the field retail, usually have fairly small numbers, and large ones manufacturing enterprises have quite high numbers.
Interest
Interest margin is one of the important indicators of a bank’s performance; it characterizes the ratio of its income and expense parts. It is used to determine the profitability of loan transactions and whether the bank can cover its costs.
This variety can be absolute or relative. Its value can be influenced by inflation rates, various types of active operations, the relationship between the bank’s capital and resources attracted from outside, etc.
Variational
Variation margin (VM) is a value that indicates the possible profit or loss on trading platforms. It is also the number by which the amount of funds taken as collateral during a trade transaction can increase or decrease.
If the trader correctly predicted the market movement, then this value will be positive. In the opposite situation it will be negative.
When the session ends, the running VM is added to the account or, vice versa, canceled.
If a trader holds his position for only one session, then the results of the trade transaction will be the same as the VM.
And if a trader holds his position for a long time, it will be added to daily, and ultimately its performance will not be the same as the outcome of the transaction.
Watch a video about what margin is:
Margin and Profit: What's the Difference?
Most people tend to think that the concepts of “margin” and “profit” are identical, and cannot understand the difference between them. However, although minor, there is still a difference, and it is important to understand it, especially for people who use these concepts every day.
Recall that margin is the difference between a company's revenue and the cost of the goods it produces. To calculate it, only variable costs are taken into account without taking into account the rest.
Profit is the result of a company’s financial activities at the end of a certain period. That is, these are the funds that remain with the enterprise after taking into account all the costs of production and marketing of goods.
In other words, the margin can be calculated this way: subtract the cost of the product from the revenue. And when profit is calculated, in addition to the cost of the product, various costs, business management costs, interest paid or received, and other types of expenses are also taken into account.
By the way, such words as “back margin” (profit from discounts, bonuses and promotional offers) and “front margin” (profit from markups) are associated with profit.
What is the difference between margin and markup?
To understand the difference between margin and markup, you must first clarify these concepts. If everything is already clear with the first word, then with the second it is not entirely clear.
The markup is the difference between the cost price and the final price of the product. In theory, it should cover all costs: production, delivery, storage and sales.
Therefore, it is clear that the markup is an addition to the cost of production, and the margin does not take this cost into account during calculation.
To make the difference between margin and markup more clear, let’s break it down into several points: - Different difference. When calculating the markup, they take the difference between the cost of goods and the purchase price, and when calculating the margin, they take the difference between the company’s revenue after sales and the cost of goods.
- Maximum volume. The markup has almost no restrictions, and it can be at least 100, at least 300 percent, but the margin cannot reach such figures.
- Basis of calculation. When calculating the margin, the company's income is taken as the base, and when calculating the markup, the cost is taken.
- Correspondence. Both quantities are always directly proportional to each other. The only thing is that the second indicator cannot exceed the first.
Margin and markup are quite common terms used not only by specialists, but also by ordinary people in everyday life, and now you know what their main differences are.
Margin calculation formula
Basic concepts:
G.P.(grossprofit) - gross margin. Reflects the difference between revenue and total costs.
C.M.(contribution margin) - marginal income (marginal profit). The difference between revenue from product sales and variable costs
TR(totalrevenue) – revenue. Income, the product of unit price and production and sales volume.
TC(totalcost) - total costs. Cost price, consisting of all costing items: materials, electricity, wages, depreciation, etc. They are divided into two types of costs – fixed and variable.
F.C.(fixed cost) - fixed costs. Costs that do not change when capacity (production volume) changes, for example, depreciation, director’s salary, etc.
V.C.(variablecost) - variable costs. Costs that increase/decrease due to changes in production volumes, for example, the earnings of key workers, raw materials, materials, etc.
Gross Margin
reflects the difference between revenue and total costs. The indicator is necessary for analyzing profit taking into account cost and is calculated using the formula: GP = TR - TC
Similarly, the difference between revenue and variable costs will be called Marginal income
and is calculated by the formula:
CM = TR - VC
Using only the gross margin (marginal income) indicator, it is impossible to assess the overall financial condition of the enterprise. These indicators are usually used to calculate a number of other important indicators: contribution margin ratio and gross margin ratio.
Gross Margin Ratio
, equal to the ratio of gross margin to the amount of sales revenue: K VM = GP/TR
Likewise Marginal Income Ratio
equal to the ratio of marginal income to the amount of sales revenue:
K MD = CM / TR
It is also called the contribution margin rate. For industrial enterprises The margin rate is 20%, for trading – 30%.
The gross margin ratio shows how much profit we will make, for example, from one dollar of revenue. If the gross margin ratio is 22%, this means that every dollar will bring us 22 cents in profit.
This value is important when it is necessary to make important decisions about enterprise management. It can be used to predict changes in profits during expected growth or decline in sales.
Interest margin
shows the ratio of total costs to revenue (income). GP = TC/TR
or variable costs to revenue:
CM=VC/TR
As we already mentioned, the concept of “margin” is used in many areas, and this may be why it can be difficult for an outsider to understand what it is. Let's take a closer look at where it is used and what definitions it gives.
In economics
Economists define it as the difference between the price of a product and its cost. That is, this is actually its main definition.
Important! In Europe, economists explain this concept as the percentage rate of the ratio of profit to product sales at the selling price and use it to understand whether the company’s activities are effective.
In general, when analyzing the results of a company’s work, the gross variety is most used, because it is it that has an impact on net profit, which is used for the further development of the enterprise by increasing fixed capital.
In banking
In banking documentation you can find such a term as credit margin. When a loan agreement is concluded, the amount of goods under this agreement and the amount actually paid to the borrower may be different. This difference is called credit.
When applying for a secured loan, there is a concept called the guarantee margin - the difference between the value of the property issued as collateral and the amount of funds issued.
Almost all banks lend and accept deposits. And in order for the bank to make a profit from this type of activity, different interest rates are set. The difference between the interest rate on loans and deposits is called the bank margin.
In exchange activities
On exchanges they use a variation variety. It is most often used on futures trading platforms. From the name it is clear that it is changeable and cannot have the same meaning. It can be positive if the trades were profitable, or negative if the trades turned out to be unprofitable.
Thus, we can conclude that the term “margin” is not so complicated. Now you can easily calculate using the formula its various types, marginal profit, its coefficient and, most importantly, you have an idea in which areas this word is used and for what purpose.
Updated 01/17/2019 at 18:19 20,139 views
EBITDA (Earnings before interest, taxes, depreciation and amortization) is earnings before interest, taxes, depreciation and amortization. The EBITDA calculation is used to measure a company's operating profitability because it only takes into account those expenses that are necessary to run the business on a "day-to-day basis." However, because of its flexibility, a significant difficulty arises when using EBITDA as a measure of profitability: since the calculation of EBITDA on the balance sheet is not officially regulated, companies can manipulate this indicator, making the business appear more profitable than it actually is.
To analyze a company's financial condition and get a complete picture of its profitability, corporate financiers and investors carefully study financial reports and balances. In this process, a number of indicators and related financial ratios are used to measure profitability. Typically, analysts consider standardized measures of profitability as set forth in generally accepted accounting principles—GAAP and IFRS—because they are easily comparable across businesses and industries. At the same time, there are indicators that are not related to them, but are also widely used in practice. One of them is EBITDA.
For example, the calculation uses only operating income as the source of income. With this definition of profit, EBITDA is most closely related to operating profit. At least in theory, excluding asset depreciation expense is the only real difference between the two figures. Since operating profit appears on a company's income statement, the easiest way to calculate EBITDA is to start with the GAAP/IFRS number and work backwards (EBITDA Calculation Formula 1)
EBITDA = Operating profit + Depreciation and amortization expense
Example of EBITDA calculation
For example, for the fiscal quarter ended June 30, 2017, the company had operating income of $128.79 million and depreciation and amortization expense of $29.05 million. The above formula for calculating EBITDA in this case will give the following result:
$128.79 million + $29.05 million = $157.84 million
However, many companies interpret the name of this indicator literally, including all expenses and sources of income, regardless of their relationship to core operations. Under this method, EBITDA is calculated based on net income and the write-off of taxes, interest and amortization. This calculation formula allows you to include in profit any additional income from investments or secondary transactions, as well as one-time payments for the sale of an asset. (EBITDA calculation formula 2):
EBITDA = Net profit + Interest + Taxes + Depreciation + Amortization
Using the example above, in addition to depreciation expense, the company has net income of $70.28 million, taxes of $56.43 million, and $2.08 million in interest. payments for the quarter. Using this calculation model, EBITDA for the same fiscal quarter would be:
$70.28 million + $2.08 million + $56.43 million + $29.05 million = $157.84 million.
It is worth noting that EBITDA formulas can give different results. Differences in EBITDA calculations may be explained by the sale of large quantities of equipment or high investment returns, but if these parameters are not explicitly stated, the result can be misleading. An unscrupulous company could easily use one calculation method this year and switch to another the next year to overestimate its performance. If the calculation method remains the same from year to year, EBITDA will be very useful for comparing historical performance.
The difference between operating margin and EBITDA
Operating margin and EBITDA are two measures of a company's profitability. Even though they are related, they show different profit measurements and different points financial analysis For the company.
Operating margin, also called operating profit margin, is one measure of a company's profit level. It is calculated as a percentage of total sales revenue, with all costs of doing business taken into account in the formula, excluding taxes, interest, investment gains or losses, and any gains or losses from events outside the company's normal business operations, such as sale of real estate, buildings, etc. Costs involved in calculating operating margin include wages and benefits for employees and independent contractors, administrative expenses, the cost of parts or materials needed to manufacture the goods sold by the company, advertising expenses and depreciation. Calculating operating margin helps companies analyze and reduce the variable costs associated with running their business.
Although the metrics used to calculate operating margin and EBITDA overlap somewhat, EBITDA is generally considered to be more closely related to net income because net income provides the base amount from which EBITDA is calculated. Net income is a rough estimate of a company's profitability because it includes all of the company's costs and expenses, taxes, interest, one-time or extraordinary expenses, and amounts that are not included in the calculation of operating income. EBITDA is the sum of net income with taxes, interest, depreciation, and amortization added to that sum. Thus, EBITDA includes both measures that are typically classified under net income (taxes and interest) and a measure that is typically classified under operating income (depreciation and amortization).
EBITDA margin and risks of using EBITDA when evaluating investments
When making an investment decision, there are two specific risks if an investor relies on EBITDA margin data:
- EBITDA margin is not a good indicator of the performance of companies with expensive equipment or equipment purchased on debt;
- EBITDA margin can hide the fact that some companies have high EBITDA but low net income and profitability.
EBITDA margin measures a company's earnings before interest, taxes, depreciation, and amortization as a percentage of its total revenue. EBITDA margin can be calculated as follows:
EBITDA margin = EBITDA/total revenue
For investors, EBITDA margin is good way evaluate the potential of a planned investment, as it provides insight into the company's performance without taking into account financial decisions, accounting decisions and many tax conditions. EBITDA margin can also provide investors with greater insight than a company's profitability metrics. EBITDA margin does not include non-operating consequences of the company's activities such as depreciation, taxes and interest payments.
Although EBITDA is of some interest to investors, it has a number of disadvantages as the main argument in decision making. For example, companies operating in industries that require large amounts of fixed assets, such as manufacturing, will not provide investors with accurate EBITDA margin performance metrics. Property, plant and equipment, typically purchased on credit, have interest payments that are not included in EBITDA and high depreciation, which is also not included in EBITDA. While EBITDA is a useful performance indicator, it does not take into account the company's net income, which can be very low to an investor and signal that the investment will be underperforming.
Thus, EBITDA is useful for comparing the net profitability of different companies for financing and accounting decisions. But when using this indicator investors need to take into account the presence of certain risks.
