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April 2014
Gross Profits, Operating Income, Net Income and EBITDA—What’s the Difference? Part Two
By Michael Waddell

     Company owners, managers, bankers, and investors often talk about profits or income when discussing the financial performance of a business, but each may focus on very different numbers. As a continuation of last month’s article, we will now look at two other earnings ratios: net profits and margins and EBITDA.

     We will define each term by using two sample companies in the coffee roasting business (see chart). Either company can be viewed as the better performing firm based on the earnings ratio that is selected.

 

Net Income is operating income less interest expense and taxes. Some company owners focus on this figure because they feel it reflects the final amount of money that the business earned. Unfortunately, income and cash flow does not always match, so owners can have positive net profits, but a negative cash flow. Positive net income should later generate a positive cash flow, but the company must successfully convert its working capital (accounts receivable plus inventory minus accounts payable) to cash at the levels reflected on the financial statements.

 

Net Margin is calculated by dividing net income by revenue. Company A’s net income and net margin are higher than Company B’s. Since both paid the same taxes, Company B’s higher interest expense is a significant difference.

 

EBITDA is Earnings Before Interest, Taxes, Depreciation and Amortization, and while it may not appear in a company’s financial statement, this figure is often used by bankers and investors. EBITDA removes the effects of financing costs (interest expense) and location costs (taxes) from earnings and adds back “non-cash” deductions to income (depreciation and amortization).

     EBITDA gives an indication of a company’s future cash flows from operations while removing the effects of financing costs and taxes that may vary by location or company structure. Looking at the components that make up EBITDA is also helpful. For example, Company B had higher interest expense. Is this because Company B is more risky from a credit standpoint, or has it financed additional or newer equipment that might later make it more efficient?

 

EBITDA / Revenue: EBITDA is dividing by revenue to compare different sized firms. While Company A’s net income and net margin was greater, Company B performs better from an EBITDA perspective.

     While no single earnings ratio can explain a business’s overall financial performance, gross profit and operating income (discussed last month) and net income do show total dollars earned at various levels of a company’s operation. Gross, operating and net margins, however, are needed to make comparisons between companies with different revenue levels.

     In our example, as we moved through each earnings ratio, the most financially profitable company switched from Company A (higher gross margin) to Company B (higher operating margin) to Company A (higher net margin) and finally to Company B (higher EBITDA and EBITDA / sales).

     Today, EBITDA is probably most often used when small business earnings are discussed by bankers and investors, because EBITDA gives an indication of the cash flow being generated from a company’s operations.

     It also serves as a good ratio for owners and managers to compare themselves against past periods and others in their industry, because non-cash expenses (depreciation and amortization) are added back to earnings and financing costs (interest) and governmental costs (taxes) are subtracted to show net earnings generated by the company.

Michael Waddell is a Financial and Management Consultant at Potter & Company.
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