Corporate accounting is required to adhere to the standards and practices collectively referred to as the generally accepted accounting principles (GAAP). In corporate finance, the term "profit margin" generally refers to one of three key GAAP-approved measures of profitability found on a company's income statement: gross profit margin, operating profit margin and net profit margin. These profitability ratios reflect the ability of a business to turn a dollar of revenue into a dollar of profit after accounting for various types of expenses. The net profit margin, which is sometimes referred to simply as the profit margin, is widely considered one of the most crucial indicators of a company's financial health.
The benefit of GAAP profit margins is that their calculation is standardized, making comparisons between a company and its competitors very straightforward. However, other metrics have been developed that measure profitability slightly differently. While they don't adhere to the GAAP standards, these metrics can be useful to a business as a means of comparing its own performance from year to year.
Non-GAAP Profitability Metrics
Two of the most common non-GAAP profitability metrics are earnings before interest and taxes (EBIT) and earnings before interest, taxes, depreciation and amortization (EBITDA). While they bear close resemblance to their GAAP counterparts in some ways, there are crucial differences. For example, gross profit reflects revenue minus only those costs directly associated with the production of goods for sale. Operating profit is equal to gross profit minus any other overhead, operational, or sales expenses necessary to run the business, including depreciation and amortization of assets. EBITDA essentially splits the difference between these two metrics by accounting for all expenses generated by production and day-to-day operations but adding back in the cost of depreciation and amortization. Like its GAAP counterparts, the EBITDA profit margin is equal to the EBITDA divided by revenue.
The difference between the EBITDA profit margin and standard profit margins is simply a matter of its exclusion from the GAAP principles. The EBITDA is still a profit margin, but prudent corporate and stock valuation includes analysis of this metric in addition to the GAAP margins rather than instead of them.