A previous article mentioned EBITDA, which is an important accounting term that stands for earnings before interest, tax, depreciation, and amortization. This is used to gauge a company’s financial health and is the backbone for important ratios like the Enterprise Value, EBITDA margin and is used in industries like private equity. It has many variations, with its more popular cousin being EBIT. EBIT is simply earnings before interest and tax.
It doesn’t account for depreciation and amortization, which accounts for the diminishing value of tangible and intangible goods, respectively. They might seem similar, but EBIT has different uses and is applicable to different industries compared to EBITDA.
What is EBIT?
As mentioned earlier, EBIT is a commonly used financial metric and stands for earnings before interest and tax. It’s a standard method to analyze a company’s profitability and is also referred to as operating profit or operating earnings. This metric is especially useful because it primarily focuses on the company’s ability to remain profitable.
Interest expense includes the interest payments a firm would pay on its debt. It also gives an insight into a company’s capital structure. Capital structure alludes to how investors fund the company, which is either through debt or equity. A common way to raise funds is by offering bonds to investors, which are simply I.O.Us. Buying bonds give investors an income stream, which is the interest the company pays along with the return of the investors’ initial investment at the end of the bond’s term. Interest expense also includes other sources of debt, like equipment financing among others.
Conversely, equity funding means that each investor becomes a part owner of the company. Equity owners have a higher risk-reward ratio as they can benefit from receiving dividends and stock price appreciation, but could lose their entire investment if the company goes bankrupt. The most common form of equity financing is by issuing stock via a process called an IPO or Initial Public Offering. This process allows a company to issue its stocks or equities for sale on public markets like the S&P 500 and NASDAQ.
Taxes and EBIT
EBIT looks at a company’s profitability, excluding its capital structure. It’s also useful when comparing similar companies with different tax rates. Taxes have a huge impact on any situation from retirement, investments, corporate finance and everything in between. Therefore, it’s smart to be able to compare companies performance on a pre-tax and after-tax basis. Some main taxes that can impact a company’s bottom line are corporate taxes and state taxes.
Some states like Texas are pro-business and have no state income tax, which has prompted many companies to relocate there. Also, corporate tax rates play an important role in international business and countries with low corporate tax rates, like Ireland, have seen an influx of new companies. This, in turn, has created a stronger Irish economy and has brought new higher paying jobs to that nation.
Fundamental EBIT calculation and ratios
It’s relatively easy to calculate EBIT and this can be accomplished using with these two formulas:
- EBIT = Revenue – Cost of Goods Sold (COGs) – operating expenses
- EBIT = Net Income + Interest + Taxes
This important figure is found on a company’s income statement, which is one, if not the most important financial statements. The other main two financial statements are the balance sheet and cash flow statements.
However, the income statement is crucial as it shows a company’s profitability throughout the year. The final annual income statement is also transferred to a business owner’s tax return on Schedule C. Having an organized income statement throughout the year will make tax season easier and allow businesses to maximize their deductions, which lowers their tax expense.
The Cost of Goods Sold or COGs figure is the second line item on the income statement and includes direct expenses that were incurred when creating a product or delivering a service. Some direct expenses include a product’s original cost or wholesale price and labor expenses like employee wages. It doesn’t include indirect costs like marketing, utilities nor shipping fees.
Here is an example of an income statement that shows EBIT in action for company XYZ:
Total Revenue: $80,000
Gross Profit: $70,000
Interest Payment: $3,000
Net Profit before Tax: $52,000
Taxes at 25%: $13,000
Net Profit: $39,000
The EBIT in this example is $55,000, which is calculated by adding the bolded line items. This scenario demonstrates how net profit and EBIT can vary as taxes and capital structure methods can greatly impact a company’s bottom line.
Like other financial figures, EBIT serves as a fundamental ingredient for important financial ratios, which include the interest coverage ratio, EBIT Margin, Return on Total Assets (ROTA), and the EBIT Enterprise multiple..
Interest coverage ratio
Formula: EBIT/Interest Expense
The Interest Coverage ratio can be calculated by taking EBIT and dividing it by the company’s interest expense for the same period. This ratio shows how a company is keeping up with its interest payments. A low ratio below 1.5 is an indicator that it’s having a hard time making interest payments. It also shows that it could be having difficulty paying off its debt in general. A good ratio can vary by industry, which is why it’s crucial to factor in common industry standards.
EBIT margin shows how profitable a company’s sales are during specific periods of time. This ratio is easy to calculate and just requires taking EBIT divided by revenue. It can also use EBIT and revenue from different time periods which include monthly, quarterly and annual figures. Another name for this term is operating margin and the average ratio for the S&P 500 was 10.7% in the final quarter of 2018.
Using the S&P is a good benchmark as it is an aggregate of the top 500 publicly traded companies in the US. While it can be a good starting point, it’s prudent to look at industry-specific standards as a good EBIT margin ratio can be good in one industry and mediocre for another.
Return on total assets (ROTA)
Formula: EBIT/Total Assets
ROTA can be found by taking EBIT divided by Total Assets and shows how effectively a company uses its assets to generate revenue. A higher percentage is optimal and if a company miraculously has a 100% ROTA, then it generates one dollar in earnings for every dollar in assets. This ideal scenario is extremely rare, if not impossible to achieve and a good ROTA starts around 5%. Keep in mind that this ratio also subtracts contra account line items like accumulated depreciation and allowance for doubtful accounts.
Accumulated depreciation is the total or cumulative depreciation of an asset up to a single point in its life. This means that companies can use the diminishing value of an asset, which is depreciation in its simplest form, to increase tax deductions, thus lowering taxable income. Allowance for doubtful accounts is a total reduction of accounts receivable and reflects the amounts that customers aren’t likely to pay.
EBIT enterprise multiple
The EBIT Enterprise Multiple is calculated by taking EV or Enterprise Value divided by EBIT. Enterprise Value is commonly used by investors and private equity firms to assign a company a selling price during mergers and acquisitions. This metric is more comprehensive than a standard Price Earnings or PE ratio. It paints a clearer picture as it’s not altered by tax rates nor capital structure conventions like debt financing.
Different variations of EBIT
EBIT is one of the main profitability figures and is commonly used like its cousin, EBITDA. Some other related profitability figures include:
- EBIAT (Earnings Before Interest After Taxes)
- EBID (Earnings Before Interest and Depreciation)
- EBIDA (Earnings Before Interest, Depreciation, and Amortization)
- EBITDAX (Earnings Before Interest, Tax, Depreciation, Amortization, and Exploration)
- EBITDAR (Earnings Before Interest, Tax, Depreciation, Amortization and Restructuring/Rent Costs)
- EBITDARM (Earnings Before Interest, Tax, Depreciation, Amortization, Rent and Management Fees)
Each ratio can be applied to specific industries based on other outside factors. For example, the oil and gas industry uses EBITDAX quite often as exploration plays a crucial role in these companies. Exploration is one of the first steps in the process to extract natural gas from shale formations and can be quite costly. It’s also included as part of the depreciation and depletion line items.
These line items are important to the oil and gas industry as companies have large depreciable machinery. Depletion is an umbrella term that refers to the total expense incurred when extracting natural resources from the earth.
Simple ways to improve EBIT
There are a few simple ways to improve EBIT, which include lowering COGs and operating expenses. As defined earlier, COGs refer to the direct costs when selling a product or service. One straightforward way to reduce COGs is to consider buying inventory in bulk, as many suppliers give discounts per large orders.
Keep in mind that it’s wise to keep track of your inventory turnover to ensure that it won’t sell too quickly nor stagnate on shelves. Having a balanced inventory will ensure that products will be sold promptly and that the business won’t run out of stock. Another way to reduce this cost is to ask for shipping discounts when purchasing in bulk.
Operating expenses are the day to day expenses of running a business and can include mortgage payments and utilities. Refinancing mortgages and evaluating the loan terms are a first, yet crucial step to take to lower EBIT. Lowering utility bills by keeping the lights off and the thermostat low while not operating is a simple, but an overlooked way to increase EBIT or a company’s earnings. Real estate and utility expenses are some of the largest expenses for most businesses and reducing these serve as an excellent way to start increasing EBIT.
EBIT vs. EBITDA
EBIT and EBITDA are very similar, with EBITDA not accounting for depreciation and amortization. Therefore, EBITDA isn’t an ideal metric for machinery intensive industries like Oil & Gas, Construction and Real Estate. Depreciation plays a significant role in these industries and EBITDA doesn’t account for this. In this case, EBIT would be more appropriate.
Also, EBITDA enterprise multiples will generally be lower than EBIT enterprise multiples, which could make companies appear undervalued. Savvy investors realize that this is inaccurate and the EBIT enterprise multiple would be more relevant for comparing different industries.
EBIT vs. Operating income
EBIT and Operating Income can be one and the same, but these figures can vary at times. For example, operating income doesn’t include non-operating income nor non-operating expenses, with net income including these options. Non operating income and expenses include figures that are derived from non-primary business operations. Some common examples of non operating income include dividend payments, foreign exchange gains, and asset write-downs. Non operating expenses could be borrowing costs (i.e interest), depreciation and amortization.
Retail shopping is a common industry in which EBIT and operating income can vary due to credit financing revenue. Many large retail chains like Macy’s and Dick’s Sporting Goods offer their customers credit cards, which provides them with credit card interest as an additional revenue source. EBIT would reflect this income while operating income wouldn’t, which is why it’s crucial to use different valuation ratios depending on the industry.
EBIT and EBITDA might seem similar, but they have many key differences. The primary difference is that EBIT doesn’t factor in depreciation or amortization. Therefore, EBIT would be a better metric to use than EBITDA for depreciation heavy industries like real estate or mining.
EBIT is more commonly used and serves as a building block for many important financial ratios. It also can be used in industries like retail shopping and banking, since they both earn significant revenue from credit financing activities. However, it’s important to know that every industry uses this figure differently based on industry-specific standards.
Disclaimer: This post isn’t tax law advice, but education. Consult a CPA or tax adviser for advice.