What is EBIT? Understanding earnings before interest and taxes

Earnings before interest and taxes (EBIT) is a simple profitability metric that any company can use when evaluating its economic performance, such as operating expenses. This is yet another formula, along with gross profit, cash flow, etc, that you need to know.

In this article, we will explore the topic and show how EBIT calculating works, its impact on a company’s profits / financial statements, and what businesses can learn from it in general.

What is EBIT?

To calculate EBIT for your business operations, we first need a clear definition. So, EBIT is a financial performance metric that measures a company’s profitability from its core operations, excluding indirect expenses like interest expenses and income taxes.

Roughly speaking, it is a gross profit minus expenses – operating expenses, that is. Thus, the formula for calculating EBIT was developed to show business efficiency. 

For example, a company’s sales revenue is $1mln, but the cost of goods sold is $700K, so if we exclude interest and taxes, EBIT would be $300K.

Unlike gross profit, earnings before interest and taxes account for all operating expenses. 

It is widely used in financial analysis to evaluate operational efficiency and profitability, making it a key metric for analysts, investors, and stakeholders. For instance, EBIT can be used to find out the operating margin, which measures the percentage of revenue that remains after covering operating expenses.

EBIT vs. EBITDA 

EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Excluding non-operating expenses such as depreciation and amortization when calculating EBITDA allows a business to differentiate its operating performance and cash flow more clearly from the company’s gross profit.

However, it is important to note that EBITDA is not a measure of cash flow, as the changes in working capital, capital expenditures, or other cash-related activities are not accounted for.  

Depreciation and amortization expenses are the key differences, as these are excluded when you calculate EBITDA but are included in EBIT.

The EBITDA formula looks like this: EBITDA = operating income + depreciation + amortization. 

EBIT is good for understanding operational performance and profitability. The EBIT calculated highlights how well companies manage their core operations and business activities.

EBITDA is more about the company’s performance in the short term based on pure operating earnings, excluding non-cash expenses. The accounting department often uses both EBITDA / EBIT in its balance sheet. 

EBIT vs. net income

EBIT focuses more on operating income, while net income represents the company’s bottom line after accounting for all expenses, including interest, taxes, depreciation, and amortization expenses.

Net income shows the overall financial performance and truly reflects the company’s profitability. 

Why are they both important for the company’s ability to make informed financial decisions?

EBIT provides a clearer picture of a company’s operating income by focusing on core activities and excluding external factors like taxes, which can vary significantly between companies and countries, irrespective of their fixed assets.

Net income is somewhat of a financial summary that reflects the company’s overall profitability, including all revenue and expenses. Learn how the net income differs from the net profit metric in this article. 

Components of EBIT

Now, let’s look at the calculation. Without interest and taxes, earnings before interest and taxes are calculated by subtracting operating expenses from the company’s revenue.

The EBIT formula = revenue – operating expenses (cost of goods sold (COGS) and other operating costs before interest and taxes.) This calculation excludes any non-operating income, interest expenses, and taxes, focusing solely on the operating profit generated by the company’s core operations.

Why are there some distinctions between operating and non-operating activities when it comes to the EBIT calculation?

Operating activities are the primary functions of the business, such as production, sales, or service delivery. These directly impact EBIT.

Non-operating activities include gains or losses from investments, interest income, or costs unrelated to core operations.

It is separated from EBIT calculations and does not reflect the company’s operational efficiency.

For an example of EBIT calculation, let’s take a look at a company, “A,” that produces and sells phones. 

Its revenue from net sales of the new phone mode is included in EBIT. Interest income from an investment is excluded because it doesn’t relate to core operations. The cost of goods sold (COGS) for the phone production is part of EBIT. Rental property cash flow, being non-operating, is excluded.

Why EBIT is important for investors

This metric is simple, which makes it a great tool to evaluate the overall operational performance of a company, including how effectively it utilizes its fixed assets. The exclusion of tax expenses and interest expenses offers a neutral metric for any company in any country with a different capital structure. 

Any investor using it can do the following:

• See profitability trends over time, and the company’s financial stability and growth potential would be like an open book.
• Compare companies across industries without the influence of financing or taxation strategies.
• Develop financial projections, allowing them to predict future earnings. However, it doesn’t account for interest, taxes, or cash flow movements.

Its straightforward calculation and relevance to operational performance make it a reliable indicator for making informed investment decisions.

Also, when it comes to assessing the core profitability of a business, financial analysts can easily see some insights just by using the earnings before interest and taxes:

• Operational strength: how well the company performs in its primary business activities.
• Operating margin: you can compare margins across companies to see how efficiently a business works.
• Growth potential: a combination of self-cost, cash flow, and net income could clearly demonstrate full potential and room to expand.

Practical applications of EBIT

So, how do the earnings before interest and taxes influence your business strategy? We picked up some of the examples..

Mergers and acquisitions. A big company initiates the acquisition of a smaller, less lucky competitor from the same industry. Before closing the deal, calculating the smaller company’s EBIT will show how well it performs operationally, excluding the impact of financing costs (such as interest expenses) and taxes, as well as its product competitiveness, how much of the company’s cash flow is actually free cash flow, etc.

Thus, earnings before interest and taxes (EBIT) will help predict post-acquisition cash flows and potential money investment for a product in this case.

Profitability analysis for product lines. A global retail parent company calculates the earnings before interest and taxes for product lines of their foreign divisions to determine which products were most successful in order to maximize profit.

As a result, the business will focus on the most high-margin products, while low-performing products will be restructured or phased out.

Benchmarking. A bank compares its EBIT margins with competitors. A lower EBIT margin would indicate higher operating costs or reduced efficiency compared to others.

In this case, using this metric is crucial to stay in touch with market prices and remain competent.

The impact of EBIT on evaluating growth opportunities

The company’s capital structure is complicated, and the calculation of EBIT and cash flow can help decide whether to expand the business or not. A significant number of companies from all over the world will face this dilemma sooner or later.

A higher EBIT margin indicates operational efficiency and may signal that the expansion is a way to go. However, in capital-intensive industries, amortization and depreciation expenses are very impactful, and using the EBIT metric will not be that helpful.

Operational cost management and EBIT

There are many important financial metrics: operational income, operational expenses, operating profit, assets, and fixed assets. To manage all these properly, lots of work needs to be done. Operational costs typically include:

• Cost of goods sold: Direct expenses associated with producing goods or services. Lowering this is one of the main competitive advantages in business. It would increase sales revenue and overall gross profit. But lowering quality may play havoc.
• Selling, general, and administrative expenses: Indirect costs like marketing, salaries, and administrative expenses. Companies, at some point, may consider layoffs. However, the business’s product depends on people, and the better the salaries are, the more people are motivated to work harder.
• Research and development (R&D): While R&D is critical for innovation, companies need to ensure it generates sufficient returns to justify the expenditure. Again, in a tech-intense industry, saving a penny on R&D may lead to a big gap, and catching up may cost a significant amount of money and time.

Finding a balance between income and expense is not so simple, but companies that are good at cost management practices can not only boost their EBIT but also strengthen their competitive position and long-term growth potential.

How Genome supports financial analysis

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Conclusion

Earnings before interest, taxes (EBIT) is yet another metric a business needs to know to properly assess the company’s operating profitability. Now that you know how to calculate EBIT, evaluating your company’s operating profit and making more informed decisions will be easier. 

FAQs

How does EBIT differ from gross profit?

Earnings before interest and taxes are operating income or revenue minus operating expenses but without any interest and taxes paid. Gross profit, however, measures revenue minus the cost of goods sold without factoring in operating costs. EBIT is about profitability; gross profit focuses on production efficiency.

Can EBIT be negative?

Yes, if a company’s operating expenses exceed its revenue. This typically indicates poor operational efficiency or insufficient net sales.

What industries rely most heavily on EBIT?

Industries with high capital and tech intensity, such as big retail, energy, pharmaceutical, and automobile manufacturing, heavily rely on EBIT to assess operational performance before financing and tax considerations.

Is EBIT affected by tax regulations?

No, and that is the point of the metric – EBIT is calculated before taxes, so it remains unaffected by any tax regulations. It isolates operational performance, allowing comparisons between companies regardless of differing tax environments or rates.

Can small businesses use EBIT effectively?

Yes, small businesses can use EBIT to evaluate profitability and operational efficiency.