EBIT vs EBITDA – What is Operating Profit? Let us have a look at the Income Statement of Colgate above. Is it EBIT (Earnings Before Interest and Taxes) or EBITDA (Earnings Before Interest Taxes Depreciation & Amortization)?
Operating profit is EBIT. EBIT defines any company’s profit including, all expenditures just leaving income tax and interest expenditures. However, EBITDA measure is good to be used for analyzing and comparing profitability between firms and businesses as it removes the impacts of accounting and financing decisions.
In this article on EBIT vs EBITDA, we look at its differences & usage in depth –
- EBIT vs EBITDA – Definition
- EBIT vs EBITDA – Key Differences
- EBIT vs EBITDA Examples
- Calculation of EBITDA of Colgate
- EBIT vs EBITDA – Capital Intensive Firms and Services Companies
- Key Points to Note about EBITDA
- EBITDA Drawbacks
EBIT vs EBITDA – Definition
In finance and accounting, earnings before interest and taxes (EBIT) defined as any company’s profit including, all expenditures just leaving income tax and interest expenditures. It is defined by the formula:
EBIT Formula = operating revenue – operating expenses or OPEX
If the company doesn’t have non-operating income for calculation purpose, then alternatively operating income may be used being similar to operating profit and EBIT.
Earnings before interest, taxes, depreciation, and amortization or EBITDA, an accounting term calculated through the firm’s net earnings, prior to interest, taxes, expenses, amortization and depreciation that are deducted, being a substitute for a firm’s existing operating profitability. It is defined by the formula:
EBITDA = EBIT or operating profit + depreciation expenditure + amortization expenditure
Or, EBITDA = Total profit + Amortization + Depreciation + Taxes + Interest
Adding the company’s overall expenditures due to amortization and depreciation back to its EBIT.
EBITDA is basically net income added to amortization, depreciation, taxes and interest. EBITDA measure is good to be used for analyzing and comparing profitability between firms and businesses as it removes the impacts of accounting and financing decisions.
Verizon provides Consolidated EBITDA as a non-GAAP measure. Verizon management believes that these measures are useful for Investors in evaluating profitability and operating performance of the company.
source: Verizon Annual Report
As seen below – EBITDA = EBIT (Operating Income) + Depreciation and Amortization.
source: Verizon Annual Report
Also, note that EBITDA most often used for evaluating valuation ratios (EV/EBITDA) as against calculating revenue and enterprise value.
EBIT vs EBITDA – Key Differences
EBIT vs EBITDA Examples
EBIT vs EBITDA – Example 1
Suppose there’s a construction company having $70,000 revenue last year. But, the firm’s operating expenditures were recorded at $40,000. Therefore, EBIT = $70,000 – $40,000 = $30,000.
The expenditures include administrative, general, selling, cost of goods sold (COGS), utilities & rent, salaries, amortization, and depreciation.
- Add any depreciation expenses
Now, extending the same example for calculating EBITDA with key assumptions including, working lifetime expectation for the asset of 10 years. Suppose the machinery purchased by the company some time back had their consolidated value of $30,000 with a working life of say 10 years. In such case, upon assuming straight-line or linear depreciation, the machinery would together depreciate by $30,000/10 = $3,000 per year.
- Add any amortization expenses
Amortization is linked to depreciation however, it isn’t same technically. Amortization denotes the expenditures witnessed from the strategic acquisition of key intangible assets any time over their complete life, while depreciation used for tangible assets. Typically, amortization expenditures are recorded in line with depreciation expenditures on any company’s P&L or cash flow statements. Sum up any listed amortization expenditures for obtaining and recording one unique value.
- For instance, assume that some time back a company expended $2,000 for obtaining the rights for some famous Sufi song to be used in the commercials. Suppose this money purchased the song rights for say five years.
- Thus, Amortization expense = $2,000/5 years = $4, 00/year
Now, calculating EBITDA using the formula,
EBITDA = EBIT + amortization + depreciation
Adding back the overall expenditures due to amortization and depreciation to the firm’s EBIT. As EBITDA is defined as the calculation of net earnings prior to amortization, depreciation, taxes and interest. As amortization and depreciation were previously subtracted for EBIT calculation, one must add them again to find EBITDA.
- In the above example about construction company, let’s believe that the amortization and depreciation expenses identified earlier are just the costs incurred by the company (actually, one might find it crucial to add numerous depreciation or/and amortization expenditures to arrive at the net value).
- For this case, let’s evaluate EBITDA through the formula, EBITDA = amortization + depreciation + EBIT. $400 + $3000 + $30,000 = $33,400. Hence, the company’s EBITDA calculated to be $33,400.
EBIT and EBITDA – Example 2
Suppose a retail firm delivers $100 million of revenue and witnesses $40 million of product expense and $20 million of operating expenditures. Amortization and depreciation expenditure recorded at $10 million, delivering net profit from operations of $30 million. Further, the interest expenditure is $5 million that makes $25 million of earnings before taxes. Assuming a tax rate of 20%, net income becomes $20 million post $5 million of taxes that are deducted from the company’s pretax income. Employing EBITDA formula, let’s sum operating profit with depreciation, amortization expenditure for arriving at the EBITDA equals to $40 million ($30 million added to $10 million).
EBIT and EBITDA – Example 3
|Company A||Company B|
|Cost of Goods||(3,555,000)||(3,470,000)|
|Gross Profit||1,945,000 35.4%||1,780,000 33.9%|
|Selling, General &|
|Operating Income||395,000 7.2%||410,000 7.8%|
|Net Income||300,000 5.5%||275,000 5.2%|
|Depreciation + Amortization||110,000||170,000|
|EBITDA||505,000 9.2%||580,000 11.1%|
In the above example, company B has illustrated better EBITDA measure compared to company A despite having comparatively smaller top line growth.
EBITDA is defined by cash flow from operations that minimizes the impact of tax policies, financing and accounting on stated profits.
Calculation of EBITDA of Colgate
Below is the snapshot of the Income Statement of Colgate. As we saw earlier, the Operating Profit reported is EBIT (Earnings Before Interest and Taxes). If you look at the Income Statement closely, you will not find line Depreciation & Amortization line item.
A further look in Colgate’s accounting disclosures reveal that Depreciation that is attributable to manufacturing operations is included in Cost of Sales (before the Gross Profit). And the remaining of the depreciation is included in the SG&A or Selling General and Admin expense.
The best and the easiest way to find Depreciation and Amortization is to look at the cash flow statement. Cash Flow from Operations includes the Depreciation and amortization figures.
EBITDA (2015) = EBIT (2015) + Depreciaton & Amortization (2016)
EBITDA 2015 = 2,789 + 449 = $3,328 million
Likewise, EBITDA (2014) = 3,557 + 442 = $3,999 million
EBIT vs EBITDA – Capital Intensive Firms and Services Companies
Let us look at a typical Services Company EBIT/EBITDA and Capital Intensive Firm (manufacturing firm) EBIT/EBITDA
Services companies do not have a large asset base, their business model is dependent on Human Capital (employees). Due to this depreciation and amortization in Servies Companies in generally non-meaningful. However, Manufacturing Companies (or Capital Intensive companies) invest heavily in its set up and are dependent on the investments in assets to manufacture goods. Therefore, with higher asset base, its depreciation and amortization is relatively higher.
Consider the example below –
|Items||Service Company A||Manufacturing Company B|
Both, the companies have equal EBITDA while company’s A EBIT is $20 billion but company’s B EBIT is merely $0 billion.
EBIT vs EBITDA of Infosys – Service Companies
The difference between EBIT margin and EBITDA margin can tell us the relative amount of depreciation and amortization in the Income Statement. We note from the graph below that the difference between EBIT Margin and EBITDA Margin for Infosys is approximately 1.24% (27.34% – 26.10%). This is expected from services firm as they operate as an Asset Light model.
EBIT vs EBITDA of Exxon (Capital Intensive Firm)
Now let us compare the above graph with that Exxon. Exxon is an Oil & Gas company (highly capital intensive firm). As expected we note that the difference between EBIT Margin and EBITDA margin is very high – approximately 8.42% (13.00% – 4.58%). This is because of heavy investments in Property Plant and Equipment that leads to high depreciation and amortization figures.
Key Points to Note about EBITDA
EBITDA Data must be used responsibly
- Never use EBITDA like a key technique for determining the company’s financial strength. EBITDA is expected to have some utility in financial study. For example, it’s a simpler technique for identifying the amount of money that the company needs to remunerate for the remaining debts over the short-term – suppose a company has $2,000 for interest payments however, $3,000 as EBITDA, it’s observed that the firm has enough money to settle its debt. But, as EBITDA don’t take into account key expenditures and since it can be easily altered, hence it’s foolish to just use it being the sole measurement of the company’s strength. (also look at Interest Coverage Ratio)
- EBITDA don’t actually prove to be an accurate indicator of if any company is making money or losing money. In reality, it’s actually possible for any company to illustrate positive EBITDA while having negative free cash flows. Therefore, EBITDA can be used to falsely make any company appear much better than it truly is.
A company’s EBITDA shouldn’t be purposefully manipulated
- EBITDA may be altered through corrupt accounting methods. For instance, as amortization and depreciation are evaluated fairly in detail (through experience, estimates, and projections), it’s likely to alter the company’s EBITDA through alterations with its amortization and depreciation plans. However amortization and depreciation are non-cash expenditures (cash has previously been swapped for the amortizing/ depreciating assets), however, they are present for some reason. Finally, intangible assets perish and equipment flops. After this takes place, extremely real cash expenditures takes place.
- As a practical case of EBITDA management, Worldcom capitalized items that should have been expensed. Capitalization increased the depreciation and resulted in higher profit (due to reduced expenses) and also reported higher EBITDA keeping the analysts happy.
Never use EBITDA multiple to misrepresent any firm
- EBITDA is not a reliable multiple for determining any company’s financial health as it can be easily altered to post a rosy picture about any company that is enough to misguide the lenders and investors. For example, in some businesses the limit for taking loans are determined by calculating the EBITDA percentage, therefore, by controlling the firm’s EBITDA, business holders can easily deceive lenders into offering huge loans as against under normal lending conditions.
- Fake practices such as these are crafted to fraud a firm’s stakeholders are corrupt and may even be unlawful.
- EBITDA is an adjusted figure that enables healthy decision-making capabilities for what must be and what must not be taken while performing the calculation. Further, it also signifies that firms often alter the elements involved while performing EBITDA calculation across different reporting periods.
- EBITDA was first introduced with leveraged buyouts during the 1980s, while it was employed to identify the capability of any company to successfully service the entire debt. With the passage of time, EBITDA became extremely popular among industries having exclusive assets that required write down over longer time periods. At present, EBITDA is most commonly used by several companies, particularly belonging to the tech segment although it stays warranted.
- Most common delusion comprises of EBITDA equivalent to the cash earnings. However, EBITDA forms a good evaluator of profitability however not cash flows. EBITDA even forgets the total cash needed for funding the working capital as well as old equipment’s replacement that may be notable. Thus, EBITDA is frequently used like an accounting trick for making any company’s earnings appear lucrative to the investors. While using this technique, it is important that stockholders also emphasize on other key performance metrics for being sure that the company isn’t hiding something under the EBITDA metric.