Profit, also commonly referred to as earnings, is considered to be the most important element in any business. Various profit amounts can be calculated through inclusion and exclusion of costs and income. Gross Margin and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) are two such earning amounts widely calculated by businesses. The key difference between gross margin and EBITDA is that gross margin is the portion of revenue after deducting the cost of goods sold whereas EBITDA excludes interest, tax, depreciation and amortization in its calculation.
CONTENTS
1. Overview and Key Difference
2. What is Gross Margin
3. What is EBITDA
4. Side by Side Comparison – Gross Margin vs EBITDA
5. Summary
What is Gross Margin?
Gross Margin or ‘gross profit’ is the revenue less cost of goods sold and can be expressed both in absolute and percentage terms. This shows the amount of revenue left after covering the cost of goods sold. Higher the GP margin, higher the efficiency in conducting the core business activity; therefore, it is the first profit figure in the income statement.
Gross Profit margin = (Revenue – Cost of Goods Sold) OR (Gross Profit / Revenue *100)
Revenue
Revenue is the income earned by conducting company’s main business activity
Cost of Goods Sold (COGS)
The cost of goods in the beginning inventory plus the net cost of goods purchased minus the cost of goods in its ending inventory.
What is EBITDA?
EBITDA calculates the earnings before interest, tax, depreciation and amortization. This calculation is used to measure a company’s operational profitability because it takes into account only those expenses necessary to run the business on a day-to-day basis.
Interest
This is the cost of debt and is payable annually. This is a contractual obligation and the interest rates are agreed at the beginning of the loan agreement. Companies can evaluate a variety of loan options to obtain benefits of lower interest rates; however, once committed to paying the interest, this becomes an uncontrollable cost.
Tax
Tax is a financial charge on earnings levied by the state; thus, it is a legal obligation. This is an expense beyond the control of the organization where tax evasion can be penalized by law.
Depreciation
Depreciation is an accounting expense to allow for the reduction in economic useful life of tangible assets due to wear and tear. There are multiple methods to depreciate tangible assets. Even though there is no major difference between the methods regarding the overall amount charged; some depreciation policies charge a higher percentage for the early years of the asset compared to latter years whereas other policies charge the same percentage over the life of the asset.
Amortization
Amortization is an accounting term that refers to the process of allocating the cost of an intangible asset over a period of time. It also refers to the repayment of loan principal over time. This is also a cost that cannot be directly controllable by the business
Interest, depreciation, and amortization are tax deductible expenses and are advantageous from a tax perspective. Since the above elements are not directly controllable, there should be an interim profit figure between gross margin and net margin to indicate how controllable income and expenses have affected net profit. EBITDA is the measure of this profit figure which allows this calculation.
EBITDA = Revenue – Expenses (excluding taxes, interest, depreciation and amortization)
EBITDA Margin = EBITDA/Revenue *100
Figure 1: Cost and incomes should be maintained effectively to obtain increasing profits.
What is the difference Between Gross Margin and EBITDA?
Gross Margin vs EBITDA |
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| Gross margin is the portion of revenue after deducting the cost of goods sold. | EBITDA is calculated excluding interest, tax, depreciation and amortization . |
| Ratio | |
| Gross Margin is calculated as = (Revenue – Cost of Goods Sold). | EBITDA is calculated as = Revenue – Expenses (excluding taxes, interest, depreciation and amortization). |
| Usage | |
| While useful, Gross Margin does not provide very useful information since it does not consider other operating income and costs. | EBITDA is a relatively new concept and provides an informed basis for decision making. |
Summary – Gross Margin vs EBITDA
The difference between gross margin and EBITDA is primarily dependent on the aspects considered in its calculation. Gross margin is calculated to indicate the profits generated from the core business activity while EBITDA is the profit amount after taking into account other operating income and expenses. Comparing the company’s gross margin and EBITDA with previous year results and with similar companies in the same industry provides increased usefulness.
Reference:
1.”EBITDA vs Gross Margin vs Net Profit.” Saasmetrics Blog. N.p., 07 Nov. 2015. Web. 10 Mar. 2017.
2.Ross, Sean. “What is the difference between amortization and depreciation?” Investopedia. N.p., 10 Feb. 2017. Web. 10 Mar. 2017.
3.Smith, Lisa. “EBITDA: Challenging The Calculation.” Investopedia. N.p., 07 Dec. 2003. Web. 10 Mar. 2017.
Image Courtesy:
1. “TescoProfitsGraph”(CC BY-SA 3.0) via Commons Wikimedia