When it comes to business finances, accounting and investing, there are a lot of acronyms, terms and concepts to get used to. These may include EBIT – and the closely related EBITDA.
As a measure of a company’s profitability, EBIT or EBITDA can be important to business owners and founders, investors and shareholders. These measures aren’t standard accounting measures, but they do allow analysts to compare different companies, across industries and countries, to get a view on their profitability.
This guide walks through what EBIT is and how it’s calculated, as well as the formula for EBITDA and how the 2 measurements can be used to assess the financial health of a business.
What Is EBIT (Earnings Before Interest and Taxes)?
EBIT stands for earnings before interest and taxes. This can also be referred to as operating profit or operating earnings. EBIT represents the revenue, or income of a company, once expenses excluding tax and interest costs have been deducted.
Removing the costs of tax and interest means this measure shows the ability of a company to be profitable, without focusing on the costs of tax or financing debt. That can be helpful in a couple of ways. If you’re an investor considering which company to buy shares in, you may want to look at the EBIT to compare businesses which are in different tax regimes. Maybe one company is in the US, and one is overseas in a country where corporate tax rates are different. By stripping out the impact of taxes you can see the basic financial health of each option before you add in the impact of local taxes.
You may also want to use EBIT if you’re looking at the financial performance of companies which have a lot of capital assets like property, which tends to be financed through debt. If the assets are needed for the growth of the business, and the debt is well managed, then the company may well be a good investment option. By removing the impact of financing debt from the profitability of the business, you can see how well it’s doing – and compare different companies to each other without penalizing those which have taken on debts to grow.
EBIT Formula
Companies do not have to report EBIT in their financial statements or reports, as it’s not a standard accounting measure. However, you can work out the EBIT for companies you’re interested in quite easily. If you’re looking at a well known company, you may find analysts have already done the work for you – search online for commentary on the latest financial statements to learn more about your chosen business.
The calculation used for EBIT is as follows:
EBIT = total revenue – cost of goods sold – operating expenses
How to calculate EBIT margin?
EBIT margin is expressed as a percentage which can make it an easier way to compare the operating efficiency of one business against another. The formula for EBIT margin is:
EBIT margin = (EBIT/net revenue) *100
What is EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization)?
Another commonly used measure to evaluate the financial performance of a business is known as EBITDA (earnings before interest, taxes, depreciation and amortization).
Like EBIT, this measure looks at the revenue of a business without taking into account the impact of taxes and interest – but also removes the impact of depreciation and amortization. Depreciation and amortization are both accounting techniques used to spread the costs of an asset out over its lifetime. In the case of depreciation, this refers to physical assets, and amortization looks at intangible assets and loans.
The reason businesses use these measures in accounting is to make sure that the cost of a large capital purchase – manufacturing equipment, for example – doesn’t only show in the financial year the item is purchased. Instead, the useful life of the equipment is calculated, and the costs are spread across that time frame. This makes sense as it shows how the asset is used – but it also makes the company look less profitable than it is in the years after the asset is purchased.
For this reason, using EBITDA allows investors and analysts looking at companies which have high levels of tangible and intangible assets to get a better measure of the current ability to produce a profit.
How to calculate EBITDA?
There are a couple of different ways to calculate EBITDA, which may produce slight variations in the result. Here’s what you need to know:
EBITDA Formula
The simplest way to calculate EBITDA is as follows:
EBITDA = operating profit + depreciation and amortization
If you don’t already know the operating profit, you can also calculate the EBITDA for a company in this way:
EBITDA = net profit + taxes + interest + depreciation and amortization
Using EBITDA to value a business
EBITDA can be helpful when comparing businesses across different industries as it removes some of the factors which can skew operating profitability. It enables investors and analysts to look at a company in an industry which has high levels of fixed assets and compare it against one which does not. EBITDA also lets analysts look at the core profitability of a business regardless of the impact of taxes.
It’s important to remember that EBIT and EBITDA are only a couple of the wide range of different measures used to assess and evaluate businesses. Both measures have their limitations, and so need to be used with care. Neither is a standard accounting measure which means companies can choose which formulas they use when producing EBIT or EBITDA figures. Relying on these measures alone may also mask some other problems – such as high levels of debt which may be unsustainable if interest rates rise, or precarious tax positions which may change and result in increased costs.
EBIT vs EBITDA
Depending on the type of business, you’ll find that either EBIT or EBITDA may be the best choice when analyzing performance and projecting future growth. EBIT gives a view of the operating profitability of a business – but EBITDA may work better when a company has fixed assets which show on accounting statements as depreciation and therefore make the business look less profitable than it is.
Neither EBIT or EBITDA is a perfect measure to assess the financial health of a business. Getting a rounded picture by using other measures, and standard accounting statements is key.
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Understanding EBIT and EBITDA can be handy, whether you own a business yourself, are considering investing, or are just interested in the intricacies of the world of corporate finance. As both are measures used widely by analysts and investors, it’s helpful to get to grips with them if you have your own company or startup and need to raise funding. They’re also a good way of looking more deeply at companies before deciding where to invest for your own future financial health.
