Earnings Before Interest and Taxes (EBIT)
EBIT (earnings before interest and taxes), also referred to as operating income, is a profitability ratio that determines the operating profits of a company by deducting of the cost of goods sold and operating from the total revenue. Put simply, EBIT is the amount of money a company makes without taking into account interest or taxes and is commonly used to this measure operating profits or operating earnings.
Earnings before interest and tax is a measure of how profitable a company is, and is often used as an alternative to operating profit. Why does EBIT ignore taxes and interest? EBIT excludes these because it focuses on the ability of a company to generate earnings from operations. The tax and capital structure are not relevant to the performance of the company.
You’ll find that EBIT is often used by investors and creditors because it helps them to see how a company is able to generate enough earnings to be profitable, fund its ongoing operations and pay down any debts.
To calculate the earnings before interest and tax of a company, you will need to deduct the cost of goods sold (COGS) as well as operating expenses from a company’s total revenue.
If you do not have the figures for the COGS, operating expenses, and total revenues, you can still calculate a company’s EBIT using the net profit method. With this method, you will need to add interest and taxes to the net profit to get company earnings before paying interest and taxes.
Using the direct costs method, you will find out what was taken out of the company’s earnings (COGS and operating expenses) and with the net profit method, you add back interest and taxes to the net income.
You can only use the net profit method for calculation of EBIT during the end of a given business period when it has prepared its financial statements and you know the value of the net income.
With the direct cost method, we can use the method to calculate EBIT any time as we can easily determine and predict total revenue, cost of goods sold, and operating expenses.
Since EBIT determines how a company will generate revenues over a particular period, it can be used by investors to compare the performances of similar companies in the same industry and determine which ones are wise to invest in.
That said, EBIT would not be a good measure for comparing companies in different industries. Manufacturing industries, for example, would have larger COGS as well as other measures compared to something like the hotel industry.
Investors and creditors can use this value to speculate how a business could run when it has no taxes or capital structure cost to worry about. This makes it helpful for investors to compare two companies in the same industry that have different tax rates.
Just as with any financial ratio, EBIT comes with its own limitations that investors need to be aware of when comparing different companies EBIT figures.
One of the primary limitations is that because EBIT ignores interest, it could artificially inflate the earnings for a company which has a large amount of debt, which generally also means interest expenses on that debt.
Not including debt into the analysis is risky because a company could have increased its debt because of bad performance or a lack of cash flow.
Another factor to consider with EBIT is depreciation, which is included in EBIT. This can lead to varied results across industries where one has a large number of fixed assets and the other doesn’t. The depreciation of the fixed assets would reduce the net income of the company and EBIT would make it look less favorable.
For that type of comparison, you may want to use EBITDA instead, which takes EBIT and also removes depreciation and amortization expenses when calculating the profitability of the company.
Let’s say you want to invest in a company that manufacture baseball caps, and they had the following figures in their income statement for the year that ended in 2017:
- Total Sales: $1,000,000
- Net Income: $80,000
- Cost of Goods Sold: $650,000
- Income Taxes: $10,000
- Gross Profit: $350,000
- Interest Expenses: $60,000.
- Operating Expenses: $200,000
Since we have all of the figures available to use, we can work out the EBIT using either the direct cost method or the net profit method. Using the direct cost method:
Using the net profit method:
Earnings Before Interest and Taxes is an important profitably measure for comparing the performances of different businesses. The below points are worth bearing in mind as a quick recap of what it is, why it’s used, and how to use it:
- EBIT calculates how a company will generate revenues over a particular period
- You can calculate the ratio using the direct cost as well as net profit method
- When calculating EBIT using the net profit method add net profit of a business to interest as well as income taxes
- To calculate EBIT with the direct cost method subtract a company’s total revenue from the cost of goods sold as well as operating expenses
- Investors and lenders wanting to see how a company could operate without tax and capital structure limitations could use EBIT
- EBIT would not be a good measure for comparing companies in different industries as they could have different operating expenses and cost of goods sold
You can use this calculator to calculate the EBIT for a company by entering total revenue, COGS, and operating expenses.
1. What is Earnings Before Interest and Taxes (EBIT)?
Earnings before interest and taxes is a profitability measure that shows how much revenue a company has generated over a particular period after subtracting the cost of goods sold and operating expenses. Put simply, it’s a measure of how much profit a company has generated from its core operations.
2. How is the Earnings Before Interest and Taxes (EBIT) calculated?
EBIT is calculated by subtracting the cost of goods sold from total revenue and then subtracting operating expenses from that figure.
The formula would be:
EBIT = Total Revenue − Cost of Goods Sold − Operating Expenses
3. What is the difference between the Earnings Before Interest and Taxes (EBIT) and the EBITDA?
EBITDA is a more comprehensive measure of profitability that includes depreciation and amortization expenses. EBITDA stands for earnings before interest, taxes, depreciation, and amortization.
While EBIT is a valuable measure, it does not consider the impact of depreciation and amortization on a company’s profits.
4. Is interest income included in the Earnings Before Interest and Taxes (EBIT)?
Interest income is included in EBIT only if it comes from primary business operations. For example, if a company has a loan from a bank that is used for its primary business operations, the interest income generated from that loan would be included in EBIT.
However, if a company has a portfolio of investments that generate interest income, that income would not be included in EBIT.
5. Why is the Earnings Before Interest and Taxes (EBIT)important?
EBIT is an important measure of profitability because it shows how much revenue a company has generated from its core operations. It is also a valuable measure for comparing the performances of different businesses.