EBIT margin: how prof­it­able is your business?

If you want to compare the success of two different companies, possibly even based in different countries, then annual net profit isn’t the best reference value. For one, different countries have different rates of tax, and on the other hand costs and revenue don’t count towards the actual success of a business. This is why the business coef­fi­cient EBIT is used for these kinds of com­par­is­on. It is used to calculate this EBIT margin. What is the EBIT margin and what can this value tell us?

The first thing to know is that EBIT stands for "earnings before interest and taxes". This business coef­fi­cient cor­res­ponds to the operating profit of a business, and was provided by the In­ter­na­tion­al Financial Reporting Standards.

You can calculate the EBIT margin by working out the ratio of a company's EBIT to its turnover. This per­cent­age value is very similar to return on sales. With this coef­fi­cient, though, annual net profit (or shortfall) is divided by turnover – plus, taxes and interest are accounted for. As a yardstick for a com­par­at­ive result that rep­res­ents corporate success, the per­cent­age re­la­tion­ship of EBIT to turnover is more suitable. This is because interest costs and interest earned aren’t really related to what the company actually does, and taxes on earnings vary from country to country.

Naturally, interest and taxes have an effect on profit, but they don’t have anything to do with output. To be able to get an idea of business activity – including and above all in com­par­is­on to other busi­nesses in­ter­na­tion­ally – we should exclude these factors. It’s for this reason that EBIT, and therefore the EBIT margin too, are more suitable coef­fi­cients for this kind of com­par­is­on.

The EBIT margin has an array of different user values:

• prof­it­ab­il­ity target: A specific target for the EBIT margin can be set when corporate planning.
• reference value: Just as with the EBIT itself, the EBIT margin can be used to compare busi­nesses from different countries with one another.
• sector com­par­is­on: The EBIT margin serves as a means for comparing companies within one sector, too.
• financing: In some situ­ations, the EBIT margin can play a role in financing busi­nesses. For example, a bank might use the EBIT margin as a meas­ure­ment of a business’ earning power, and therefore its credit risk.

Turnover refers to the money (or the claims) that a company takes through selling goods and/or services. EBIT includes all costs that are incurred either directly or in­dir­ectly in providing these goods/services. Taxes and interests, as we have said, are not taken into account. The EBIT margin is the pro­por­tion of EBIT to turnover. The higher this coef­fi­cient, the greater the success of the company in com­par­is­on.

The EBIT margin plays a major role in comparing sectors because the success of a company within its own sector can be estimated in this way. When comparing different sectors with one another, the average EBIT margin also makes it possible to draw con­clu­sions about typical business struc­tures. Different sectors can present very different average EBIT margins. Software companies can easily reach margins of 25%, and some man­u­fac­tur­ers can even have a dazzling EBIT margin of 30 to 40%. On the other hand, even suc­cess­ful busi­nesses in retail tend to lie in single figures.

Despite the higher EBIT value, the EBIT margin of the second business is much lower (9%) than that of the first (16%), meaning that the second company has made a higher operative profit than the first, but is less prof­it­able in com­par­is­on. The two busi­nesses can still be compared via the EBIT margin even if they aren’t based in the same country, since taxes and interest are not taken into account.

Please note the legal dis­claim­er relating to this article.