EBITDA vs. gross profit – A quick overview
Gross profit and EBITDA (earnings before interest, taxes, depreciation, and amortization) show different forms of a company's profit. Both financial metrics can be found on the income statement and are used to assess the company's financial performance.
However, the two metrics are calculated differently. EBITDA considers variable and fixed costs, giving a complete view of a company's profitability. On the other hand, gross profit only considers variable costs and excludes fixed costs. Gross profit shows how profitable the actual product is after subtracting the material expenses of that product. It does not account for any fixed costs.
Investors and financial analysts usually look at both financial metrics. However, they prefer to look at EBITDA first as it gives a more comprehensive view of a company's profitability.
What is gross profit?
Gross profit is the income earned by a company after subtracting the direct cost of production or cost of goods sold (COGS). It measures how profitable the products sold by the company are.
For example, if Apple sells you an iPhone for USD 1,000 and has material costs of USD 600, it makes USD 400 in gross profit. Naturally, this figure excludes the iPhone's fixed costs and development costs. We only discuss revenues minus material costs directly linked to one unit sold.
How to calculate gross profit
The formula to calculate gross profit is pretty simple. It's the first two line items of the income statement:
Total revenue
Material expenses or Cost of goods sold (COGS)
(=) Gross profit
Revenues are the total income from the sale of products. COGS are direct labor associated with producing the said product. In simple terms, you can think of them as material costs. The more products you sell, the more material costs and direct labor you will have. These costs are also referred to as variable costs. When you subtract COGS from sales revenue, you end up with gross profit.
The higher gross profit, the more efficiently a company produces its products. However, gross profit is only one part of profitability. Expenses unrelated to the units produced, such as administration, rent or marketing costs, are not included. That's where EBITDA comes in.
What is EBITDA?
EBITDA stands for earnings before interest, tax, depreciation and amortization. It is a vital measure of a company's operational profitability and can be found in the income statement. It is the quickest proxy for cash flow and the most used profitability figure.
Investors will look at EBITDA first to determine the profitability of core business operations. A positive EBITDA figure means that the company generates profit.
If EBITDA is negative, that's a big red flag and a sign of a distressed case. Further, investors use EBITDA to make overall profitability comparable to other potential targets.
How to calculate EBITDA
Gross profit reduced by selling, general and administrative Expenses ("SG&A") results in EBITDA. Thus, EBITDA excludes capital structures and tax regimes. You are considering sales revenue – variable costs – fixed costs.
The formula to calculate EBITDA is the following:
Total revenue
(-) Material expenses or Cost of goods sold (COGS)
(=) Gross profit
Selling, general, and administrative expenses (SG&A)
(=) EBITDA
(-) Depreciation and amortization (D&A)
(=) EBIT
We continue subtracting selling, general, and administrative expenses (SG&A) based on the already calculated gross profit. You can think of SG&As as operating costs that are fixed and that the company must pay regardless of how much revenue it generates, such as personnel expenses, marketing expenses, rent or recurring software expenses like server hosting fees.
It's essential to remember that EBITDA excludes depreciation and amortization (D&A) because it is a non-cash expense. When calculating EBITDA, pay attention to whether the listed SG&As already include depreciation and amortization or not.
Generally accepted accounting principles may vary. If SG&As already include D&A, you must find D&A in the company's cash flow statement and exclude it to calculate EBITDA. So, it's a little bit tricky every time.
Advantages of EBITDA
EBITDA is a quick proxy for cash flow and a company's financial health. You simply add depreciation expenses as a shortcut to cash flow. You get a quick picture of the company's financial performance without sifting through the income and cash flow statements.
By excluding financing and accounting decisions, different companies' overall profitability is comparable. You are excluding financing and taxation differences from company to company. Investors can compare different companies to one another as well as compare various industries with each other.
Disadvantages of EBITDA
However, EBITDA also has its limits. EBITDA is just a proxy for cash flow.
It is not free cash flow. EBITDA excludes capital expenditures, interest expenses and debt repayments. Consequently, EBITDA usually overstates cash flow.
A company with a positive EBITDA figure may be on the verge of bankruptcy. EBITDA is the first solid indicator of profitability but does not equal cash flow.
EBITDA vs. gross profit compared
EBITDA and gross profit are two ways to assess a company's financial health. On the one hand, EBITDA is the overall measure of profitability and factors in COGS and SG&As. Conversely, gross profit only measures profitability based on material expenses by only accounting for COGS.
EBITDA is the figure that investors will look at initially to assess the overall operating profit of a company. Does this company make money? They will also use EBITDA to compare companies to other companies. How much money do these other companies make? A high EBITDA figure, together with high EBITDA margins, are indicators of a healthy business model.
Next, investors will look at gross margin in combination with the EBITDA margin, which reveals additional information about the company's business model and operations.
Can EBITDA be higher than gross profit?
No. EBITDA is never higher than gross profit. Gross profit is always higher than EBITDA. EBITDA and gross profit measure different things.
Gross profit measures how much profit is left after subtracting COGS. In other words, the variable costs. All direct costs associated with making the product. These costs are also referred to as material costs.
On the other hand, EBITDA measures overall profitability, including all operating expenses, which means variable costs plus fixed costs. Fixed costs are expenses that do not change with the volume of produced and sold products, such as administrative expenses.
Why Is EBITDA more important than gross profit?
Investors typically look at EBITDA first before diving into a more detailed financial statement analysis. EBITDA gives a more comprehensive overview of the company's profitability. EBITDA accounts for all operating expenses, meaning both variable and fixed costs. Gross profit only accounts for variable costs directly linked to the volume of products sold.
So, EBITDA is the more complete measure when assessing a company's profitability quickly. Gross profit gives an incomplete picture. It only considers cost of goods sold while excluding fixed costs.
While EBITDA is more critical than gross profit, it also has flaws. It is a quick measure of profitability but excludes actual cash flow. Companies with a positive EBITDA figure may be on the brink of bankruptcy. EBITDA does not include capital expenditures and debt repayments.
Is EBITDA considered profit?
EBITDA is one way to measure profitability. It is earnings before interest, taxes, depreciation, and amortization. In other words, the EBITDA calculation excludes debt financing costs, taxes and depreciation expense on equipment purchases.
EBITDA is one form of profit that includes most operating costs. It gives an idea of the overall profit margin of the business model. It does not equal gross profit or net profit.
EBITDA vs. net income
EBITDA is earnings before interest, taxes, depreciation, and amortization. All the line items excluded in the EBITDA calculation are included in net income. It is also referred to as net profit and is the last line on the P&L. Net profit is the company's total profit after all expenses, taxes and interest are paid.
The net profit margin is net profit divided by the company's revenue. It tells you how much a company retains from initial revenues after accounting for all costs.
Where does it leave us?
EBITDA and gross profit are both different ways to analyze profitability. EBITDA includes both fixed and variable costs. Gross profit only includes variable costs.
Investors and financial analysts will initially look at EBITDA to assess the business model's overall profitability and operational efficiency. Then, they will look at both gross profit and EBITDA together. This will give them a quick feeling of how the business model works.
