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What is Earnings Before Interest and Taxes (EBIT)?

EBIT is also known as operating income or put simply, the income before any interest or taxes are paid for by the company.

This is used as a measurement of a company’s profitability.

When companies or stakeholders want to know the core operations of the company alone without the capital structure and tax expenses in consideration, the computation for EBIT is used.

Typically, potential investors are interested in a company’s EBIT.

The formula of EBIT can be any of the following:

EBIT = Net Income – Interest Expenses – Taxes

-or-

EBIT = Net Revenue – Cost of Good Sold – Operating Expenses

An overview of the step by step calculation based on the above formula can be shown through the following example:

Suppose Company XYZ is interested in investing in Company F that manufactures custom-made furniture.

Upon receiving the Income Statement of Company F, Company XYZ found these following information:

Net Revenue: \$650,000

Cost of Goods Sold (COGS): \$375,000

Gross Profit: \$275,000

Operating Expenses: \$100,000

To compute the EBIT, the net revenue must first be taken out (\$650,000).

The COGS are then to be subtracted from the Net Revenue (375,000) to arrive at the Gross Profit (\$275,000).

The operating expenses (\$100,000) are then subtracted from the Gross Profit. The EBIT is therefore \$175,000.

 Net Revenue \$ 650,000.00 Cost of Goods Sold \$ (375,000.00) Gross Profit \$ 275,000.00 Operating Expenses \$ (100,000.00) EBIT \$ 175,000.00

Understanding Earnings Before Interest and Taxes

Stakeholders of a company are interested in the EBIT because it is one of the most useful metrics to measure how a company is able to generate enough income in order for the company to continuously operate, pay its obligations and stay in the business for years to come.

EBIT is synonymous with operating profit because it only takes into consideration the necessary expenses for the company to operate, not including taxes and expenses related to the company’s capital structure.

EBIT and Taxes

When investors are looking at companies that fall under the same industry, it is helpful to look at each company’s EBIT because they might not have the same tax rates.

This is especially critical when investors need to make comparisons to decide which company they wish to buy stocks from.

Without including the taxes, the comparisons will just be focused on the profitability of the company.

Making a comparison based on net income might not work for companies in the same industry because some companies receive tax breaks and that would mean a higher net income for them.

EBIT and Debt

Just the same as investors making comparisons across companies within the same industries, interest expenses also need to be taken out of consideration.

This is because some companies are capital intensive or have more fixed assets in their books – these fixed assets (property, plant, and equipment) in particular are expensive and are primarily financed by debts.

When companies have more debt, they pay higher interest expenses.

Higher interest expenses leads to companies reporting less in net income.

Investors need a way to evaluate a company’s profitability without having to consider interest expenses because a well-managed debt will benefit a capital-intensive company in the long run.

EBIT Applications

There are many applications for EBIT since it is not considered as a metric of GAAP.

In the reported financial statements, you will not be able to see a label for EBIT.

Usually, the computation starts with determining the net revenue of a company and then subtracting the total operating expenses.

For some companies that have reported extraordinary items, they may be taken out because they do not form part of the normal operations of the company.

Examples of extraordinary expenses would be loss due to flood or other calamities, or gain from sale of an asset, etc.

However, if a company reports other income, they may be included.

This makes EBIT very distinct from operating income because other income does not necessarily form part of the operating income of a company.

EBIT vs. EBITDA

EBIT is Earnings Before Interest and Taxes while EBITDA is Earnings Before Interest, Taxes, Depreciation and Amortization.

To compute for EBITDA, simply take EBIT and subtract the depreciation and amortization expense of the company.

Both EBIT and EBITDA subtracts the interest and taxes paid. However, there are distinct differences between the two.

EBIT measures profitability by removing interest and taxes. EBITDA measures profitability by removing interest, taxes and depreciation.

Depreciation – considered as a non-cash expense and the cost of assets spread across its useful life – can have a significant impact on a company’s net profit.

When a company reports a significant amount of fixed assets, the depreciation expense recorded can be higher which can lead to a company reporting less profit.

Limitations of EBIT

When computing for EBIT, the profitability of a company is computed while still considering depreciation.

When different companies are compared in terms of EBIT, those with high depreciation expenses will result in lesser operating income.

Removing interest expense can become problematic in the analysis of a company’s profitability particularly if a company has a significant amount of debt due to poor cash flow or sales performance for a period.

These are areas that need to be looked at and considered when making investing decisions.

When investors plan on making investments, it is ideal if they hire a professional accounting firm to calculate EBIT because the computation can be difficult for people who are unfamiliar with it.

Why is EBIT important?

Looking at the EBIT of companies is helpful to understand their profitability simply from the core of their operations, without having to include non-operating expenses like interest and taxes which can significantly affect the income of a company.

How do analysts and investors use EBIT?

There are two financial ratios that use EBIT for financial analysis.

They are the Interest Coverage Ratio and the EBIT/EV Multiple.

Interest Coverage Ratio is used to analyze how a company can easily pay for interest on their outstanding debt and is computed by dividing EBIT by the interest expense.

EBIT/EV Multiple is a metric used to compute a company’s earnings yield and is computed by dividing EBIT by the enterprise value of a company.

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1. Harvard Business School "Cash Flow vs. Profit: What's the Difference?" Page 1 . December 3, 2021

2. NYU Stern "Measures of Profitability " Page 1 . December 3, 2021