Measures a company's profitability before accounting for financial costs and is crucial for assessing operational efficiency and performance
EBIT, or Earnings Before Interest and Taxes, is a financial metric on a company's income statement. It represents operating income by deducting all operating expenses, except interest and taxes, from revenue.
It measures a company's profitability before accounting for financial costs and is crucial for assessing operational efficiency and performance. It is also called operating income or operating profit.
This profitability metric is monitored by analysts and investors alike as it shows how well a company is managed.
- EBIT, or Earnings Before Interest and Taxes, is a financial metric representing a company's operating income.
- It is calculated by deducting all operating expenses except interest and taxes from revenue and is a crucial indicator of operational efficiency and performance.
- EBIT measures a company's profitability before accounting for financial costs, offering insights into its ability to generate profits and manage debt.
- EBIT is crucial for comparison, valuation, understanding a company's profitability from core operations, and assessing its ability to cover debt obligations and invest in new projects.
EBIT, also known as operating profit, gauges a company's operational profitability by focusing solely on earnings generated from its core activities.
Unlike conventional financial metrics, EBIT disregards taxes and interest expenses, offering insights into a company's capability to generate profits, manage debt, and sustain its ongoing functions.
Although not a standard GAAP metric and absent from official financial statements, EBIT can be disclosed as operating profits in a company's income statement.
This is derived by deducting operating expenses, including the cost of goods sold, from the total revenue or sales. Additionally, companies may incorporate non-operating income, such as investment returns, into this calculation.
The inclusion of interest income in EBIT hinges on the company's industry:
- If the company provides credit to customers as a fundamental part of its operations, the interest income is considered part of the operating income
- If the interest income originates from bond investments, it might be excluded from the calculation
There are two methods to calculate Earnings Before Interest and Taxes (EBIT).
- One approach involves beginning with EBITDA and subtracting depreciation and amortization
- Alternatively, for companies not employing the EBITDA metric, operating income can be determined by deducting Selling, General, and Administrative (SG&A) expenses (excluding interest but including depreciation) from gross profit
The formula includes:
EBIT = Net Income + Interest + Tax
EBIT = EBITDA - Depreciation - Amortization
The above methods only consider the income and expenses from the business's core operations. Often, Earnings Before Interest and Taxes can include non-recurring, one-time expenses, such as legal fees, restructuring costs, stock-based compensation, and income and expenses from non-operating profit.
Non-operating income is not associated with the company's day-to-day dealings. Instead, it relates to income from investments, such as dividends, profit, or loss, including foreign exchange (FX).
In addition, interest income can be included; however, interest expense is always excluded from the calculation.
From this perspective, it represents a more detailed operating profit metric, as it can include both operating and non-operating income and expenses.
However, as EBIT isn't part of the Generally Accepted Accounting Principles or GAAP, it can differ for different companies, depending on what the management wants to include in its calculation.
It appears near the bottom of the income statement and is one of the final subtotals before net income.
As a profit and management efficiency metric, the EBIT has a relation to other items included on the income statement. They are codependent.
The interrelation of EBIT with other measures, such as EBITDA on the income statement, is illustrated below:
|(-) Direct Expenses||xxx|
|= Gross Profit||xxx|
|(-) Indirect operating expenses, excluding depreciation and amortization||xxx|
|= EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization)||xxx|
|(-) Depreciation and amortization||xxx|
|= EBIT (Earnings Before Interest and Taxes)||xxx|
|= EBT (Earnings before tax)||xxx|
|= Net income||xxx|
The following sections present the differences between other income statement elements.
EBIT and Net Income
Net income is the bottom line of a company's financial statement and the only line in an income statement that gives you a sense of profitability. It tells us how much money the business made or lost in a given period.
On the other hand, EBIT is an indicator that reflects a company's operating income before interest and taxes are accounted for, indicating its profitability from core operations. It excludes non-operating income and expenses.
Non-operating expenses could also be included in the calculation.
It's important to note that Earnings Before Interest and Taxes (EBIT) excludes interest and taxes from its calculation, providing a clear view of a company's operational profitability before these financial obligations are taken into account.
EBIT and Taxes
Earnings Before Interest and Taxes have their merits. However, because it’s not adjusted for taxes, it could present an incomplete view of the company’s financial situation.
It could be significantly affected by the firm’s, especially when comparing it to one that has a much different capital structure. For example, similar companies with higher debt levels may end up with a higher profit as interest is a tax-deductible expense.
Earnings Before Interest and Taxes tells only half of the story when you consider taxes. First, you must know how much of your operating income is taxable and the effective tax rate.
So, what to do if we want to evaluate EBIT but don’t want to include the effect of taxes?
One solution is to useor Earnings Before Taxes. EBT is calculated by subtracting all expenses, including interest, from sales revenue before deducting taxes.
It provides insight into a company’s earnings before accounting for taxes on profits. It gives us a better idea of how much money the business can keep in its pockets before paying taxes on its profits.
It is particularly helpful for investors looking at companies in various tax jurisdictions and wanting to analyze their performance without prejudice to the impact of taxes.
EBIT and Debt
Earnings Before Interest and Taxes is one of the most important numbers in a company’s financial statements to debtholders because it shows how much profit is available for them.
The higher the Earnings Before Interest and Taxes, the higher the company can cover its debt obligations, such as interest and capital repayments, and raise additional debt and lower rates.
Like, EBIT considers the capital provided by debtholders to the company and is a much more reliable way to measure its .
It can also be used as a quick proxy in coverage ratios instead of operating cash flows. When adjusted for changes inbalances, Earnings Before Interest and Taxes can serve as a proxy for from operations.
Interest payments on outstanding debt are then deducted from operating cash flows to arrive at the total cash flow to equity holders.
If a company has a positive (+) EBIT but a negative (-) EBT, it could be a sign that it is not following an optimal capital structure. In this particular case, the company is probably over-leveraged to the point that the debt raised is the reason for incurring losses.
EBIT and Free Cash Flow (FCF)
Free cash flow is the amount of cash generated by a company’s core operations and can be calculated as:
Earnings Before Interest and Taxes - fixed and working capital expenditure
It represents how much cash a company has on hand to invest in new projects or return to shareholders through dividends or buybacks.
It is essential to compare the free cash flow with other similar-sized firms operating in the same industry. Companies with higher margins will typically have higher FCF.
The difference between these concepts is that non-cash expenses like depreciation and amortization can influence the former. At the same time, the latter only considers cash-based expenses.
FCF is used more often for valuation, especially as part of DCF or multiples analysis, as it is less prone to manipulation by accounting gimmicks.
To better understand EBIT, we’ll take a hypothetical example below. Let’s assume that company A has the following financial data expressed in millions.
|Cost of Goods Sold (COGS) incl. D&A||46,154|
|Operating income (EBITDA)||21,235|
|Non-operating interest income||155|
Following the calculations:
EBIT = Sales - Operating and non-operating expenses
This is the top-down approach.
If Earnings Before Interest and Taxes are calculated using the bottom-up method, then the calculation will read:
EBIT = Net Income + Tax - Non-operating interest income - Non-operating income/expense + Interest
The main characteristics include:
- Metric of profitability: It shows whether a business makes enough money to keep its operations going and generate profits.
- Straightforward comparison metric: It excludes taxes and debt interest; it makes it easy to compare companies that may have different interest and tax rates, depending on their geographical location.
- Depreciation and amortization adjusted: Earnings Before Interest and Taxes consider depreciation and amortization of assets. This is useful because assets will have to be replaced, and as such, taking into account D&A provides a more accurate representation of the company’s finances.
Some of the factors include:
- High depreciation: A company with many fixed assets will have higher depreciation than a business with fewer fixed assets. Companies in the manufacturing, oil and gas, mining, and commercial real estate industries usually have many fixed assets; hence, they will have more depreciation costs. The higher depreciation expenses will impact EBIT.
- Interest payment: Highly leveraged firms will pay more interest on the debt. As interest is excluded from Earnings Before Interest and Taxes, this may present inexact results that mislead investors. As the capital structure is not considered, a high amount of debt may cause concern if the firm doesn’t generate enough money to cover its obligations.
- Discrepancies in tax jurisdictions: The exclusion of taxes from it may impact the viable comparison of the firms in the same industry but in different tax jurisdictions.
- If an investor compares firm A, located in Bahrain, a low tax country, and firm B, with tax residency in Brazil, a high corporate tax country, then Earnings Before Interest and Taxes may not be that useful. Other metrics and ratios should complement it.
The operating profit is an essential metric for the company and investors. It is used as a:
Method of comparison
It compares a company’s performance between different periods and relative to other businesses in the same industry.
The return on total assets (ROTA) ratio enables analysts and investors to determine how much profit a company’s assets make. The ratio is as follows:
ROTA = EBIT / Average Total Assets
The use of EBIT helps to understand the profits generated by the assets without the impact of interest expenses and taxes. The higher the ratio, the more money a company makes from its assets. It also signals that the business uses its assets efficiently and optimally.
Relative valuation technique
The EV/EBIT multiples ratio, which compares the enterprise value to the operating income, is used by investors to understand if the stock is over or underpriced. This ratio also informs investors about the earnings yield of the company.
A low EV/EBIT ratio can signal that a stock is undervalued, while a high ratio typically means the company is overvalued. The following readings of the ratio help to understand the financial situation of a company:
- A value of or around 0 - It means that the company has no profits and will have a difficult time attracting investors.
- A value of 1 or more - It means that the company is profitable.
- A value of 2 or more - It indicates that the firm can be overvalued.
Proxy for unlevered free cash flow (FCF)
Earnings Before Interest and Taxes can be a good proxy for free cash flow for mature companies with consistent capital expenditure (CapEx), such as automobile, oil, energy, utilities, and transportation industries.
Unlevered FCF is the cash flow available to a company before paying its obligations. You can build a financial model in Excel and calculate it using the following formula:
FCF = EBIT (1 - T) + D&A + ΔNWC – CapEx
- FCF: Free cash flow
- T: Average Tax rate
- D&A: Depreciation and amortization
- ΔNWC: Change in net working capital
- CapEx: Capital expenditure
Normalization of earnings
Earnings Before Interest and Taxes allow analysts and investors to compare companies in the same sector but have different capital structures and debt interest schedules.
Both are profitability metrics that allow comparison between companies and can be used as proxies for operating cash flows. They have similarities and differences that are outlined below.
First, let’s take a look at some of the similarities:
|Valuation multiples||Used for comparing and valuing companies in relation to enterprise value (EV) to obtain valuation multiples. A high EV / EBIT ratio suggests overvaluation, while a low ratio indicates undervaluation, presenting a buying opportunity.||Utilized for comparing and valuing companies in relation to enterprise value (EV) to derive valuation multiples. A high EV / EBITDA ratio can indicate overvaluation and a low ratio may suggest undervaluation, presenting a buying opportunity.|
|Cash availability||Measure operating performance, representing cash flows available to debt holders, shareholders, and the government. These metrics are not adjusted for taxes and interest.||Measure operating performance, reflecting cash flows available to debt holders, shareholders, and the government. These metrics are not adjusted for taxes and interest.|
|Non-GAAP metrics||Both are non-GAAP metrics, allowing companies to customize the calculation, including income and expenses from non-core operating activities.||Both are non-GAAP metrics, enabling companies to tailor the calculation, including income and expenses from non-core operating activities.|
Now, let’s understand what are the differences between the two:
|Depreciation and amortization||EBIT includes depreciation and amortization expenses, reflecting wear and tear on fixed assets.||EBITDA excludes depreciation and amortization, which are significant non-cash expenses for capital-intensive sectors. Not accounting for these costs may lead to flawed analysis.|
|Capital expenditure (CapEx)||EBIT partially incorporates CapEx, accounting for cash flows after subtracting depreciation.||EBITDA doesn’t account for CapEx, considering cash flows available before deducting depreciation.|
|Rent and lease expenses||Under GAAP, both EBIT and EBITDA deduct full rent expenses. Under IFRS, rent is capitalized, and depreciation on the leased asset is deducted from EBIT but excluded from EBITDA.||Under GAAP, both EBIT and EBITDA deduct full rent expenses. Under IFRS, rent is capitalized, and depreciation on the leased asset is deducted from EBIT but excluded from EBITDA.|
To continue learning and advancing your career, check out these additional helpful WSO resources: