EBIT is an acronym for Earnings Before Interest and Taxes. It represents a company’s net income without the deduction of tax and interest. In other words, EBIT is a company’s revenue less other expenses apart from interest and tax.
Typically, you use Earnings Before Interest and Taxes to measure a company’s profitability from its operations. It is sometimes referred to as the operating income because it is gotten from sales revenue minus all operating expenses.
Why Is EBIT Important to Investors?
One of the most important factors investors consider before investing in a company is the company’s profitability. It is risky to invest in a company or business that does not have a proven track record of making operational profits. Such a company will most likely depend on external funding to sustain operations, which implies they mostly run on debts.
This is where EBIT comes in handy for investors. They use the EBIT metric to ascertain whether a company can generate enough income to settle debts, finance regular operations, and still maintain profitability.
The EBIT is particularly useful in monitoring the profit trendline of a business. It gives investors an overview of how profitable a business has been over a long period. This is a critical assessment to determine the viability of investing in a company.
EBIT & Taxes
EBIT provides an assessment of a company’s income and profit without taking tax into account. This can be very useful for investors comparing two or more companies having varying tax situations. For instance, a tax break or a reduction in the United States’ corporate tax most likely increases a company’s net income.
If you’re comparing companies based on net profit alone, a company with lower tax may seem to perform better than another of the same income level but with a higher tax. But, without adding tax to the equation, investors may have a clearer view of each company’s earnings and profitability outside of tax. In essence, EBIT tries to eliminate tax benefit/bias when assessing a company’s profitability.
EBIT & Debt
Companies operating primarily with fixed assets are more likely to have more debts. This is because acquiring fixed assets such as lands, heavy-duty equipment, plant, and other physical properties require more capital. Such companies mainly depend on loans and other means of external funding to get these capital assets.
These debts imply that such capital-intensive companies accumulate more interest expenses. However, these debts may be (and are more often than not) instrumental to the companies’ growth in the long run. An instance is a company in the oil and gas sector or companies under industrial agriculture.
Comparing two companies with the same earnings but different amounts of debts may give a biased advantage to one over the other. EBIT helps to eliminate such advantages and offers investors a good idea of a company’s real earning power without debt or interest.
What Financial Ratios Use EBIT?
Investors do not only use EBIT to determine the profitability of a company. There are other financial ratios in fundamental analysis that make use of the EBIT. Some of those financial ratios include:
Interest Coverage Ratio
This is a ratio of a company’s profitability to its debt. It helps investors to analyze a company’s ability to pay the interests on its due outstanding debts. It is one of the metrics used by investors to ascertain the riskiness of investing in a business.
The higher the coverage ratio, the better for the company. The formula for calculating the interest coverage ratio is:
ICR = EBIT / Interest Expenses
This is a financial ratio that analyses how a company’s earnings impact its enterprise value. High EBIT/EV multiple signifies that a company has a higher level of cash amount compared to its level of debts. Hence, the higher the multiple, the better for an investor.
How To Calculate EBIT
The formula for calculating Earnings Before Interest and Taxes is:
- EBIT = Revenue – Cost of Goods Sold – Operating Expenses
Let’s break the formula down into simple calculation steps.
- Get the value for the company’s revenue. This can be extracted from the top part of the Income Statement.
- Deduct the value of the COGS from the revenue. This results in gross profit. The COGS is also found on the Income Statement.
- Deduct the Operating Expenses from your result. The final output is the EBIT. You can also find the operating expenses on the Income Statement
The EBIT can also be calculated as:
- EBIT = Net Income + Interests + Taxes
Cost of Goods Sold (COGS) Formula
The Cost of Goods Sold involves all the direct expenses incurred in the production of goods. It does not include indirect costs such as sales, marketing, and overhead costs.
The formula for COGS is:
- COGS = Starting Inventory + Purchases Within the Period – Ending Inventory
Operating Revenue Formula
The Operating Revenue of a business is the income generated from the business’s primary activities. The activities that yield the revenue is dependent on the type of business involved. For instance, a bathing salon’s operating revenue is generated from the hair services they provide.
Example of EBIT
Suppose a company (say Company T) gives the following figures from their financial statement:
Revenue = $20,000
Purchases within the year (P) = $6,000
Opening Inventory (OI) = $4,000
Closing Inventory (CI) = $2,200
Operating Expenses = $2,000
To calculate the EBIT, we apply the formula as follows:
EBIT = Revenue – COGS – Operating Expenses
COGS = OI + P – CI = $4000 + $6,000 – $2,200
COGS = $7,800
EBIT = $20,000 – $7,800 – $2,000
EBIT = $10,200
Limitations of EBIT
Although EBIT helps investors determine the profitability of a company, it may not always be accurate for profitability assessments. Different companies operate different kinds of debts and assets, which leads to varying interest expenses and depreciation. These variances may introduce a bias when using EBIT to compare companies from various sectors.
Depreciation spreads the cost of a tangible asset throughout its useful life. It primarily applies to fixed assets that are capital intensive. Depreciation expense is included in the calculation of EBIT.
Companies with higher amounts of fixed assets tend to have higher depreciation expenses than those with lesser fixed assets. Depreciation expenses reduce net income and, consequently, also reduces the EBIT value. Hence, companies with higher depreciation expenses will be disadvantaged when compared with companies with lesser fixed assets.
The higher the debt a company is owing, the more interest expense it has. If a company has a large debt, profitability may be affected when the interest expenses are deducted. But since EBIT does not take interest expenses into account, the earnings of companies with large amounts of debt are inflated.
Suppose you compare two companies with the same amount of revenue but with different debts and interest expenses. The company with more debts may seem as profitable as the other one, whereas in the real sense, adding the interest expenses will reduce the net income.
The inflation of earnings caused by removing interest expenses from the EBIT calculations may lead to investors’ erroneous assessments. Companies with higher debts may reduce drastically in profitability when their interest expenses are taken into account.
EBIT, EBITDA, and EBT
All of EBIT, EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation), and EBT (Earnings Before Taxes) are metrics for calculating a business’s profitability. However, there are differences in the parameters used for each calculation. Let’s consider the differences between them.
Earnings Before Interest, Taxes, Depreciation, and Amortization is calculated by removing Depreciation and Amortization from the EBIT value. However, EBITDA does not include taxes and Interest expenses, just like EBIT.
To calculate EBITDA, take the Net Income value and add interest, taxes, depreciation, and amortization to it. Adding back depreciation and amortization can alter companies’ profitability, especially those with large amounts of fixed assets.
The higher the amount of depreciation and amortization, the higher the value of EBITDA. Since both depreciation and amortization are still expenses, the EBITDA may not give a balanced view of a company’s profitability compared with another company with lesser fixed assets.
Earnings Before Tax takes the value of a company’s net income and adds the tax expenses to it to calculate the company’s profit. Hence, EBT includes interest but excludes tax expenses.
The EBT helps compare companies with different tax rates. For example, it can be used to compare companies’ profitability in two different states in the United States that have different tax rates for other sectors and industries.
The major advantage of EBT is that it helps investors to evaluate and compare the profitability of companies independent of external factors that are not within their control.
Bottom Line: Understanding EBIT
EBIT is an essential factor to consider when trying to determine which company to invest in. It helps investors figure out the possibility of a company’s ability to sustain profit after deducting expenses and whether a company can maintain profitability for a long time.