As investors, we all know that the earnings of a company are of paramount importance to the growth of the business as well as creation and growth of shareholder wealth. Question then arises on how the earnings should be measured. In US, the Generally Accepted Accounting Procedures (GAAP), specifies the way a company can recognize its revenue and expense. Like most investors, you are undoubtedly familiar with the terms “earnings”, “net income”, and, “earnings per share“.
Then there is EBIT.
What is Earnings Before Interest and Taxes? How to Calculate EBIT?
Earnings before interest and taxes (EBIT) is the net income of a company before the tax expense and interest expense are taken off.
EBIT is equivalent to Operating Income for companies that do not have non-operating income. In such cases,
EBIT = Revenue – Operating Expense (OPEX)
EBIT is a relevant measure for investors who wish to be neutral to the effect of the interest expense (capital structure) and the income taxes. Some scenarios where this is desirable is for an investor who is contemplating an acquisition of the company and then recapitalizing it.
In other cases, EBIT provides a cleaner way to compare operational efficiency of two companies as the varying tax rates and interest expense can distort the picture.
Some value investors are partial to using EBIT in place of Net Income. Although this is a cleaner picture of company earnings power, it is still confounded by depreciation, amortization and other non cash charges. EBITDA, a related metric, removes depreciation and amortization values from the EBIT and this mitigates many of the distortion problems.
When Should You Use EBIT?
In most cases, the regular net income or earnings per share is sufficient to analyze a business or stock. The accounting principles apply uniformly to all businesses in the country, and while large capital expenses can skew the earnings in any given year, on average over time the earnings will accurately reflect the profit and loss performance of the company.
You should however consider adjusting for Interest when you wish to compare two companies solely in terms of their earnings efficiency (without the effect of the capital structure). In cases where you are comparing companies in the same industry but differing tax rates (for example a US and a foreign company, or if a company uses tax loss carryovers to reduce its period taxable income), it is appropriate to adjust for taxes.
In either case, whether you use a simple earnings, or whether you use EBIT, as long as you are aware of the reasons and potential pitfalls, you will be able to make intelligent investment decisions.
Further Refinement of Operating Profit: EBITDA
EBITDA is EBIT that is further adjusted for Depreciation and Amortization, two non-cash affecting accounting entries. Removing Depreciation and Amortization can give a more realistic picture of the company’s operating profit. It is quite possible for a company to have negative net income and EBIT but a positive EBITDA. In such cases it is evident that the company is booking depreciation and/or amortization on their financial statements and the cash flow and the operations are more profitable than they may seem. Sometimes a company may book the non-cash expenses on an aggressive schedule to get it out of the way quicker. EBITDA removes this distortion.