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# Don't judge a firm's health by its profits

When you visit a doctor, whether for an ailment or a general check, inevitably the doctor will check your pulse. That is exactly what the Ebitda margin is, to someone who looks at the financial statements of a company, for measuring its health.

Ebitda stands for earnings before interest, tax, depreciation and amortisation. We first take into account the company's net income. This is the sales, less any levy such as excise duty. Many analysts calculate adjusted Ebitda, in which case you will subtract any non-operating income from the net income. Non-operating income is any income that is not recurring in nature or does not accrue from regular operations of the company, for example income from the sale of an asset.

The next step is to calculate the COGS, or the cost of goods sold. The COGS is simply what it cost the company to make the goods it sold. So, we start with the cost of raw materials we consumed in production for the year. The next step is to add any other direct costs the company incurred in production. This could be the cost of power, labour, plant maintenance or any cost incurred for production of goods.

Finally, we need to remove the impact of increase or decrease in inventory, as we are calculating the cost of 'goods sold' and not the cost of 'goods produced'. This includes calculating the inventory of both finished goods and raw materials.

Assume a company has 100 cars as inventory and produces another 150. In the entire year, it sells 200 cars. This means the inventory has reduced to 50 cars. What is the cost of the goods sold? The cost of producing 150 cars (add the raw material and other prod costs for the year plus the cost of producing 50 cars last year (the change in inventory). So, any reduction in inventory means you used the previous year's production and you need to add its cost to your COGS, else you will show extraordinary operating margins.

Thus, we will take the cost of producing goods and add the inventory costs if the company used last year's inventory or reduce the inventory costs if it produced more than it sold in this year. We can find gross profit now, by subtracting the COGS from the net income. Next, we need to calculate all other operating expenses (like employees’ cost) and deduct these from gross profit. This will give us the Ebitda. To calculate Ebitda margin, simply divide this figure by sales. It is always expressed as a percentage.

By now, you might be wondering what all the fuss is about. Can't we simply look at the net profit margin of the company to know how profitable the company is? No, we cannot.

If you look at a company that is expanding aggressively, you can see a more pronounced impact on the net profits. This is because; the depreciation will be high. Leverage is another reason why companies often show lower profit after tax, though they are still doing well on an operating basis. The interest payments tend to be higher and that can reduce net profits. Pantaloons performance from financial year 2007 to 2010 is an example of the impact of aggressive expansion on the net profit.

Adjusted Ebitda is an even better indicator of operating health, as it includes only operating income. For example, in fourth quarter of financial year 2008, Tech Mahindra recorded a loss of Rs 221 crore due to an exclusivity payment made to a customer. If you compare the net profit margin of third and fourth quarter, you would find it declining drastically. However, the adjusted Ebitda margin was up marginally.

For all the above cases, to judge a company one should look at the Ebitda margin of the company and compare it against its peers or even its results across the years. An Ebitda margin that contrasts other indicators is not necessarily a reason for comfort or panic. It is an indicator that calls for a drill-down into the operations of the company. The writer works for www.learnwithflip.com