EBIT or the operating income is the profitability measurement which determines the company’s operating profit and is calculated by deducting the cost of the goods sold and the operating expenses incurred by the company from the total revenue.
- It shows the amount of profit that the company generates from its operating activities only.
- Here the expenses pertaining to the interest and taxes are not considered for calculating the EBIT as they do not arise due to the operating activities and that’s why it means operating profit or operating earnings.
Components of Earnings Before Interest and Tax
#1 – Revenue
Revenue is the main source of income in the business which is generated from the sale of goods and services during the normal course of its business.
#2 – Cost of Goods Sold (COGS)
Cost of goods sold refers to the direct cost incurred in the production of finished goods and the sale of services. This cost includes the purchase cost of raw material, direct labor, and other direct overhead expenses. The formula for the cost of goods sold is:
COGS = Opening inventory + purchases of raw material + direct labor + overheads – closing inventory
#3 – Operating Expenses
Operating expenses are the expenses which are incurred by the business in the normal course of its operations. It includes selling, general and administrative expenses like rent expenses, salary to administrative staff, traveling expenses etc.
It can be calculated by using the direct and indirect method.
#1 – Direct Method
Earnings Before Interest and Tax = Revenue – Cost of goods sold – Operating Expenses
This EBIT formula for the direct method is it deducts the associated expenses directly from the revenue generated
#2 – Indirect Method
Earnings Before Interest and Tax = Net income + Interest expenses + Tax expense
We have a company named ABC Inc. having revenue of $4,000, COGS of $1,500 and operating expenses of $200.
EBIT directly deducts the cost incurred from the earnings whereas the second equation adds back the interest and taxes as EBIT itself says that it is earnings before interest and taxes. This distinction is different as it allows the users to understand the concept of EBIT from two different perspectives.
The first is to see EBIT from preliminary operations perspective while the other is to see it as a year-end profitability perspective. Although both the equation will derive the same number but to analyze the number from a different perspective is important from the point of view of investors.
If the interest is the main source of income of the business like in case of bank and financial institutions then such interest income is to be included in the Earnings Before Interest and Tax.
Let’s take an example of Harry Corporation who has the manufacturing business of Gadgets. The income statement of Harry Corporation reported the following activities.
- Revenue from operations: $2,500,000
- COGS: $1,400,000
- Operating Expenses:$400,000
- Interest Expense: $200,000
- Tax Expense: $30,000
Now from the below figures we can calculate gross profit (Revenue – COGS)
= $2,500,000 – $550,000
Gross Profit = $1,100,000
And net income formula = Gross profit – Operating Expense – Interest expense – tax expense
= $1,100,000 – $400,000 – $200,000 – $30,000
Net Income = $470,000
Now we need to calculate Earnings Before Interest and Tax from the two equations:
By Direct Method
= $2,500,000 – $1,400,000- $400,000 = $700,000
By Indirect Method
= $470,000 + $200,000 + $30,000 = $700,000
- It can give a clue about the company’s earning potential. It is a crucial figure which attracts the potential buyers and the investors. Through the figure of EBIT, investors can analyze the return they can earn from the investment in the company.
- EBIT is used by the investors and creditors as it helps them to know about the success of the core operations of the business without worrying about the tax implications and the company’s cost of the capital structure. Moreover, they can simply check whether the activities of the business and their ideas are actually working in the real world or not.
- As compared to the other financial ratios earnings before interest and taxes are easy to calculate as well as simple to understand. So as a user the first figure which provides a basic understanding of the company is EBIT.
- Depreciation is considered while calculating the EBIT. While comparing the results of different industries, due to depreciation variations in the result will be there. For example, if the person is comparing earnings before interest and taxes of a company having a significant amount of the fixed assets with that of the company having few fixed assets then due to depreciation expense company with fixed assets will have the less earnings before interest and taxes as the expense leads to the reduction in the net income or the profit.
- The companies having a large portion of finance through debt will surely have a huge amount of interest expense. Earnings before interest and taxes do not consider such interest expense resulting in the inflation of the earning potential of the company. Non-consideration of the interest expense may misguide the investors as there is a possibility that due to the poor sales performance or the decreased cash flow, the company has taken huge loans. But EBIT fails to get the attention of the investors towards such high debts.
- It is important to set an industry standard as a benchmark while doing the comparison of any financial metric of two companies. Simply the comparison of the operating profits of two companies is not enough as it doesn’t tell the investor about the company’s earning potential as compared to the other companies working in the same industry.
- Also, it is necessary to create trends while evaluating the earning potential companies the like comparison of prior years with the current year to check if there exists a trend.
Earnings before interest and taxes measure the profit of the firm from its operations. The use of earnings before interest and taxes is not limited to its calculation but it is also used as an input while calculating financial ratios like operating margin ratio, interest coverage ratio etc. Also to calculate the degrees of various leverages we need to calculate EBIT.
This has been a guide to what is EBIT, its meaning and formula. Here we discuss how to calculate Earnings Before Interest and Tax along with practical examples. You may learn more about accounting from the following articles –