EBIT and EBITDA are two common ways to calculate a company’s profits, and investors may come across both terms when reviewing a company’s financial statements. Though they appear similar, they can present two very different views of a company’s income and expenses.
If you’re an investor or you own a business, it’s important to understand the difference between EBIT and EBITDA and know why the distinction matters.
What Is EBIT?
EBIT is a way to measure a company’s operating income. So what does EBIT stand for in finance? It’s an acronym that stands for “earnings before interest and taxes”.
Here’s a look at what each of those components means:
• Earnings: This is the net income of a company over a specified period of time, such as a quarter or fiscal year.
• Interest: This refers to interest payments made to any liabilities owed by the company, including loans or lines of credit.
• Taxes: This refers to any taxes a company must pay under federal and state laws.
The formula for calculating EBIT is simple.
EBIT = Net income + Interest + Taxes
The EBIT calculation assumes you know a company’s net income. To determine net income, you would use this formula:
Net income = Revenue – Cost of Goods Sold – Expenses
In this formula, revenue means the total amount of income generated by goods or services the company sells. Cost of goods sold refers to the cost of making or acquiring any goods the company sells, including labor or raw materials. Expenses include operating costs such as rent, utilities or payroll.
EBIT should not be confused with EBT, or earnings before tax. Earnings before tax is used to measure profits with taxes factored in, but not any interest payments the company owes. You may use this metric to evaluate companies that are subject to different taxation rules at the state level.
You can find EBIT listed on a company’s income or profit and loss statement alongside other important financial ratios, such as earnings per share (EPS).
Is Depreciation Included in EBIT?
The short answer is no, depreciation is not included in the context of the EBIT formula. But you will see depreciation factored in when calculating EBITDA (more on that down below).
What EBIT Tells Investors
Knowing the EBIT for a company can tell you how financially healthy that company is based on its business operations. Specifically, EBIT can tell you things like:
• How much operating income a company needs to stay in business
• What level of earnings a company generates
• How efficiently the company uses earnings when debt obligations aren’t factored in
EBIT can be useful in determining how well a company manages business operations before external factors like debt and taxes come into play. It can also help to create a framework for evaluating whether certain actions, such as a stock buyback, are a true sign that a company is struggling financially.
You can also use EBIT to determine interest coverage ratio. This ratio can tell you how easily a company is able to pay interest on outstanding debt obligations. To find the interest coverage ratio, you’d divide a company’s earnings before interest and taxes by any interest paid toward debt for the specific time period you’re measuring. As an investor, this ratio can give you insight into how well a company is able to keep up with its current debts and any debts it may take on down the line.
What Is EBITDA?
EBITDA is another acronym you may see on financial statements that stands for “earnings before interest, taxes, depreciation, and amortization”. In terms of the first three terms, the breakdown is exactly the same as for EBIT. Plus there are two new additions:
• Depreciation: This term is used to refer to the decline in an asset’s value over time due to things like regular use, wear and tear or becoming obsolete.
• Amortization: This term also applies to a decline in value but instead of a tangible asset, it can be used for intangible assets. Amortization can also be referred to in the context of borrowing. For example, a business loan amortization schedule would show how the balance declines over time as payments are made.
So what is the EBITDA formula? It looks like this:
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
Alternately, you can substitute this formula instead:
EBITDA = Operating Profit + Depreciation + Amortization
In this formula, operating profit is the same thing as EBIT. So to calculate EBITDA, you’d first need to calculate earnings before interest and taxes.
You should be able to find all the information you need to calculate EBITDA on a company’s income statement, though you may also need a cash flow statement for an accurate calculation.
EBIT vs EBITDA: Which is Better?
Compared to EBIT, EBITDA offers a clearer snapshot of a company’s net cash flow and how money is moving in or out of the business.
Calculating the earnings before interest, taxes, depreciation, and amortization can offer a fuller picture of a company’s financial health in terms of how operational decision-making affects profitability. It can also be useful when calculating valuations for different companies and/or comparing a business to its competitors.
While EBIT and EBITDA can be a starting point for choosing where to put your money, it’s also helpful to consider other fundamental ratios such as earnings per share or price-to-earnings ratio. Active traders who are interested in benefiting from market momentum, may consider technical analysis indicators instead.
Drawbacks of EBIT vs. EBITDA
While EBIT and EBITDA can be useful, there are some potential issues to be aware of. Chiefly, neither formula is considered part of Generally Accepted Account Principles (GAAP). This is a uniform set of standards that’s designed to encourage transparency and accuracy in accounting for corporations, governments and other entities.
In other words, EBIT and EBITDA don’t have any official seal of approval from an accounting authority. That means companies can manipulate the numbers in their favor, if they choose to.
Here’s why: The better a company looks on paper, the easier it may be to attract investors or qualify for financing. Companies that are struggling behind the scenes may use inflated numbers or leave out critical information when calculating EBIT or EBITDA to appear more financially stable than they are.
That could potentially lead to losses for investors who choose to put money into a company because they accepted EBIT or EBITDA calculations at face value. So it’s important to dig deeper when deciding where to invest, as these numbers may not provide a full picture of a company’s financial situation.
EBIT, or earnings before interest and tax, and EBITDA, or earnings before interest, tax, depreciation and amortization, are two ways to assess the financial health of a company. But these figures can be manipulated by companies looking to present a rosy outlook to investors, so as always, it’s a good idea to research a company from a variety of different angles before investing in it.
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