Growth in profits and revenues are the key parts of financial results. But they do not give the entire picture. Analysts thus like to read the fine print and find out if there are any stress factors. On the basis of this analysis, they give the outlook for future performance of the company, and consecutively, its stock.
Revenues and profits don’t always grow equally. The amount of increase in revenues may not always bring along a corresponding rise in profits. This is because a lot more factors are involved other than sales, which eat into profits. Sometimes, these could be a temporary phenomenon. It does not mean that the underlying business stops being profitable.
For this purpose, analysts look at EBITDA or Earnings before Interest, Taxation, Depreciation and Amortization to measure profitability. It is calculated by subtracting a company’s expenses excluding interest and tax payments, depreciation in assets, and working capital, from its total revenues. This is because other expenses vary depending on the industry. These factors thus need to be eliminated when comparing two different companies.
Operating efficiencies are also measured through operating profit. However, many analysts consider Earnings Before Interest and Taxation (EBIT), to accurately reflect the operating profit.
Interest payments depend on the way a company raises money – equity or debt. Taxation defers from company to company as different sectors have different tax liabilities. Depreciation is the gradual fall in the value of an asset, while amortization takes into consideration capital expenses over a period of time. For example, the value of a patent divided by the time it is valid for could be considered amortization. All these factors are included in the net profit. Hence, it cannot be used as a common yardstick.
For this reason, EBITDA comes handy as it shows exactly how much a company is earning from its key operations and expenses. It, thus, reflects profitability and the ability of a company to generate cash from sales. It also does away with one-time factors. EBITDA is mainly useful to understand companies with heavy tangible or intangible assets or those with significant debt.
EBITDA, when written as a percentage of total revenue, gives the EBITDA margin. It shows how efficiently the company is generating its revenue. The higher the EBITDA margin, the more capable is the company in earning with minimum expenses.
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