Operating margin and EBITDA, or earnings before interest, taxes, depreciation, and amortization, are two measures of a company's profitability. The two metrics are related but provide different insights into the financial health of a company.
Operating profit margin is a profitability ratio that investors and analysts use to evaluate a company's ability to turn a dollar of revenue into a dollar of profit after accounting for expenses. In other words, operating margin is the percentage of revenue left over after accounting for expenses.
Two components go into calculating operating profit margin: revenue and operating profit.
Revenue is listed on the top line of a company's income statement and represents the total income generated from the sale of goods or services. Revenue is also referred to as net sales.
Operating profit is the profit remaining after all of the day-to-day operating expenses have been taken out of revenue. However, some costs are not included in operating profit such as interest on debt, taxes paid, profit or loss from investments, and any extraordinary gains or losses that have occurred outside of the company's daily operations such as the sale of an asset.
The day-to-day expenses included in figuring the operating profit margin include wages and benefits for employees and independent contractors, administrative costs, the cost of parts or materials required to produce items a company sells, advertising costs, and depreciation and amortization. In short, any expense necessary to keep a business running is included, such as rent, utilities, payroll, employee benefits, and insurance premiums.
While operating profit is the dollar amount of profit generated for a period, operating profit margin is the percentage of revenue a company earns after taking out operating expenses. The formula is as follows:
Examining the operating margin helps companies analyze, and hopefully reduce, variable costs involved in conducting their business.
EBITDA or earnings before interest, taxes, depreciation, and amortization is slightly different from operating profit. EBITDA strips out the cost of debt capital and its tax effects by adding back interest and taxes to net profit. EBITDA also removes depreciation and amortization, a non-cash expense, from earnings.
Depreciation is an accounting method of allocating the cost of a fixed asset over its useful life and is used to account for declines in value over time. In other words, depreciation allows a company to expense long-term asset purchases over many years, helping a company generate profit from deploying the asset.
Depreciation and amortization expense is subtracted from revenue when calculating operating profit. EBITDA, on the other hand, adds depreciation and amortization back into operating profit as shown by the formula below:
EBITDA = Operating Income + Depreciation and Amortization
EBITDA helps to show the operating performance of a company before accounting expenses like depreciation are taking out of operating income. EBITDA can be used to analyze and compare profitability among companies and industries as it eliminates the effects of financing and accounting decisions.
For example, a capital-intensive company with a large number of fixed assets would have a lower operating profit due to the depreciation expense of the assets when compared to a company with fewer fixed assets. EBITDA takes out depreciation so that the two companies can be compared without any accounting measures affecting profit.
For more on operating margin and EBITDA including examples, please read What is considered a healthy operating profit margin? And How are gross profit and EBITDA different?