EBIT (Earnings Before Interest and Tax)

EBIT Meaning

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.

You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: EBIT (Earnings Before Interest and Tax) (wallstreetmojo.com)

Components of Earnings Before Interest and Tax

Components of Earnings Before Interest and Tax

You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: EBIT (Earnings Before Interest and Tax) (wallstreetmojo.com)

#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)

The cost of goods soldCost Of Goods SoldThe cost of goods sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company.read more 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 COGS 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 expensesSelling, General And Administrative ExpensesSelling, general and administrative (SG&A) expense includes all the expenses incurred in the selling of the products of the company whether direct or indirect along with the entire general and the administrative expenses during an accounting period under consideration such as advertisement expenses, sales promotion expenses, marketing salaries, etc.read more like rent expenses, salary to administrative staff, traveling expenses, etc.

EBIT Formula

It can be calculated by using direct and indirect methods.

#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

EBIT Examples

Example #1

We have a company named ABC Inc., having revenue of $4,000, COGS of $1,500, and operating expenses of $200.

Ebit eg1

EBIT directly deducts the cost incurredThe Cost IncurredIncurred Cost refers to an expense that a Company needs to pay in exchange for the usage of a service, product, or asset. This might include direct, indirect, production, operating, & distribution charges incurred for business operations. read more 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 a 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 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.

Example #2

Let’s take an example of Harry Corporation, which has the manufacturing business of Gadgets. The income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more 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)

Ebit2

= $2,500,000 – $550,000

Gross Profit = $1,100,000

And net income formulaNet Income FormulaNet Income formula is calculated by deducting direct and indirect expenses from the total revenue of a business.. It is the most important number for the Company, analysts, investors, and shareholders of the Company as it measures the profit earned by the Company over a period of time.read more = Gross profit – Operating Expense – Interest expense – tax expense

ebit3

= $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

Ebit eg2

= $2,500,000 – $1,400,000- $400,000 = $700,000

By Indirect Method

ebit3.1

= $470,000 + $200,000 + $30,000 = $700,000

Advantages

  • It can give a clue about the company’s earning potential. It is a crucial figure which attracts potential buyers and 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.

Limitation

Importance

  • It is important to set an industry standard as a benchmark while making 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 potential earning companies the like comparison of prior years with the current year to check if there exists a trend.

Conclusion

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 ratiosCalculating Financial RatiosFinancial ratios are indications of a company's financial performance. There are several forms of financial ratios that indicate the company's results, financial risks, and operational efficiency, such as the liquidity ratio, asset turnover ratio, operating profitability ratios, business risk ratios, financial risk ratio, stability ratios, and so on.read more like operating margin ratio, interest coverage ratioInterest Coverage RatioThe interest coverage ratio indicates how many times a company's current earnings before interest and taxes can be used to pay interest on its outstanding debt. It can be used to determine a company's liquidity position by evaluating how easily it can pay interest on its outstanding debt.read more, etc. Also, to calculate the degrees of various leverages, we need to calculate EBIT.

This has been a guide to what EBIT is, its meaning, and its 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 –

Reader Interactions

Leave a Reply

Your email address will not be published. Required fields are marked *