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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?
EBIT margin – definition
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 is the ratio of EBIT to the turnover a business makes. This relationship provides us with information about the business’ profitability, and helps to compare sectors and businesses.
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.
How to calculate the EBIT margin
The EBIT margin represents the percentage relationship between EBIT and turnover. As a formula, then, we could say:
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.
An example of the EBIT margin
The EBIT margin can be easily illustrated with this example: take two companies. The first company had a turnover of £.5 million a year. The EBIT is £240,000.
The second company was able to record a turnover of £4 million, but its EBIT is £360,000.
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.