What Is EBIT (Earnings Before Interest And Tax)?
EBIT, or the operating income, is the profitability measurement that 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 only shows the amount of profit the company generates from its operating activities. Here, the interest and taxes expenses are not considered for calculating the EBIT as they do not arise due to the operating activities, which means operating profit or operating earningsOperating EarningsOperating Earnings is the amount of profit a company earns after deducting direct and indirect costs from sales revenue. It is also referred to as EBIT, which stands for profits before interest and taxes..
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EBIT (Earnings Before Interest And Tax) Explained
Earnings before interest and taxes measure the firm’s profit from its operations. The use of earnings before interest and taxes is not limited to its calculation. Still, it is also used as 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. like operating margin, interest coverage, etc. Also, to calculate the degrees of various leverages, we need to calculate EBIT.
It is important to calculate earnings before interest and taxes and set an industry standard as a benchmark while comparing any financial metric of two companies. Simply comparing the operating profits of two companies is not enough as it doesn’t tell the investor about the company’s earning potential compared to the other companies working in the same industry.
Also, it is necessary to create trends while evaluating the potential earning companies and comparing prior years with the current year to check if there exists a trend. Thus, this measure serves as a perfect method for evaluating the performance or profitability of the core business operations. It gives clarity regarding the company’s financial health before taking into account the interest payment and taxes. It acts as a guidance for future financial decision and growth prospects so that it can stay ahead of its competitors and continue to increase and retain the existing customer base. This will provide sutainibility and ensure growth and expansion.
When we try to calculate earnings before interest and taxes, there are many components of the income statement of the company that we need to consider carefully so as to get the desired result. Let us study them in detail.
#1 – Revenue
Revenue is the main source of income in the business, which is generated from the sale of goods and services during its normal 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. refers to the direct cost incurred in producing finished goods and selling services. This includes the purchase cost of raw materials, direct labor, and other 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 expenses 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. like rent, salary to administrative staff, traveling expenses, etc.
It is necessary to understand the above components in detail so that the concept can be used successfully for calculation and evaluation by identifying the proper items from financial statement of the company. However, the above are explained in very simple terms whereas the actual process may be complex with a lot of other related items to be accounted for. It depends on the type of business, the size of operations etc.
Let us understand the formula used for calculation of the same.
The earnings before interest and tax formula uses 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 deducts the associated expenses directly from the revenue generated when we calculate earnings before interest and taxes.
#2 – Indirect Method
Earnings Before Interest and Tax = Net income + Interest expenses + Tax expense
Thus, the above details explain how to calculate earnings before interest and tax.
Let us take some examples to see how to calculate earnings before interest and taxes.
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 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. 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 EBITfrom two perspectives.
The first is to see EBIT from a preliminary operations perspective, while the other is to see it from a year-end profitability perspective. Although both the equations will derive the same number, analyzing the number from a different perspective is important from the investors’ point of view.
If interest is the main source of income of the business-like in the case of banks and financial institutions, then such interest income is to be included in the earnings before interest and tax formula.
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. 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 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. = 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
The above examples show the use of formula EBIT earnings before interest and taxes`and method of calculation of EBIT in details. The examples clearly points out step by step how to identify the items from the financial statements and evaluate the profitability by using both direct and indirect method.
This financial metric is used to depict the operating performance of the company. In order to understand the topic, it is necessary to understand its advantages and disadvantages of earnings before interest and taxes formula too. Let us study the advantages first.
- 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.
- The investors and creditors use EBIT as it helps them to know about the success of the business’s core operations 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 working in the real world or not.
- Compared to the other financial ratios, earnings before interest and taxes are easy to calculate and simple to understand. So as a user, the first figure which provides a basic understanding of the company is EBIT.
- It allows a better comparability among companies because it excludes the interest and tax part from the calculation, which tends to vary among different companies and sectors and influence the profitability.
- The method of EBIT earnings before interest and taxes is also a useful metric for analysing the historical trends. The historical data is typically used to understand the company performance in the current times and forecast the future. This helps in making informed financial decisions.
Now let us study the disadvantages also.
- DepreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. is considered while we calculate earnings before interest and taxes. While comparing the results of different industries, 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 expenses company with fixed assets will have the fewer earnings before interest and taxes as the expense leads to the reduction in the net income or the profit.
- Companies with a large portion of finance through debt will surely have a huge interest expenseInterest ExpenseInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense.. Earnings before interest and taxes do not consider such interest expense resulting in the inflation of the company’s earning potential. 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 flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. , the company has taken huge loans. But EBIT fails to get the attention of the investors towards such high debts.
- EBIT also does not reflect the cash flows of the business. Details of cash flow is very essential indicator to understand whether the company has the ability to meet its short- and long-term financial obligations or not, which will again decide its future growth prospects.
- The method offers a very limited information about the capital structure of the business. If interest and taxes are taken into consideration during evaluation of earnings, it provides clear information about the amount of debt that the company has to repay, which also signifies the level of financial risk or obligation. The tax part will clarify any kind of tax exemptions applicable, which again points out at the level of loans borrowed. Thus, the capital structure information is missing.
- For tax planning purpose, this method is not suitable because it does not account for the tax obligation which is important for making financial decisions.
- The process is vulnerable to manipulation and misrepresentation of data to portray a profitable picture about the business. It distorts the accounting practices which may include capitalization of expenses and revenue recognition policies that are normally followed in any business. Therefore it is extremely important to scrutinize the books of accounts before implementation.
Therefore, evaluation of advantages and disadvantages is very important while understanding any financial concept so that they can be implemented for the purpose of comparing profitability and performance. Thus, even though the method is widely used in business and financial market to understand company performance, it is important to use it in conjunction with various other metrics in order to get a clear and precise about the organization’s performance and make future financial planning.
This has guide to what is EBIT. We explain its formula, components, along with examples, advantages and disadvantages. You may learn more about accounting from the following articles –