2020-11-23 11:09:01 Taxes English Learn all about EBIT and how to calculate it. Correctly calculating EBIT can help you make informed business decisions based on reporting... https://quickbooks.intuit.com/ca/resources/ca_qrc/uploads/2020/11/what-is-ebit.png https://quickbooks.intuit.com/ca/resources/taxes/what-is-ebit-and-how-to-calculate-it/ What is EBIT and How to Calculate It

What is EBIT and How to Calculate It

10 min read

EBIT is Earnings Before Interest and Taxes. It reports a firm’s earnings before interest and tax expenses are added to operating costs.

This article defines EBIT, and explains the calculation. You’ll learn why EBIT is important, and how to use the formula to make informed business decisions from reporting insights. Finally, this discussion covers the pros and cons of using EBIT, and the difference between EBIT and EBITDA.

 

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What is EBIT?

EBIT is a measure of operating profit, and it’s important to note that EBIT is different from a firm’s net income. A company’s profitability, when considering all expenses, is net income.

Net income (or net profit) is defined as revenue less expenses, and EBIT excludes interest expenses and income taxes from the net income calculation. If a business generates a profit, net income will be less than the EBIT balance, because net income includes more expenses (interest expense and tax expense).

How is EBIT calculated?

There are two methods to calculate EBIT, and both formulas generate the same result.

EBIT formula

1. Total revenue: cost of goods sold – operating expenses

This formula is based on the multi-step income statement formula, which is (revenue – cost of sales – operating expenses – non-operating expenses). Here is an explanation of each component of the formula:

  • Revenue includes sales, and other transactions that generate cash inflows, including a gain on the sale of an asset.
  • Cost of goods sold includes material and labor costs that are directly related to the product or services sold.
  • Operating expenses include costs that are not directly related to the product, including insurance expenses and rent or mortgage costs.
  • Interest payments and the income tax expense are non-operating expenses.

Version one of the EBIT formula excludes the two non-operating expenses (interest expense and tax expense). Version two, on the other hand, starts with net income.

2. Net income + interest expense + tax expense

Keep in mind that net income is calculated as revenue less all expenses. This version of EBIT takes net income and adds back interest expense and tax expense. The result is the same dollar amount as version one.

An EBIT example

As an example throughout, meet Jane, the owner of Hillside Manufacturing, a furniture manufacturer. Here is Hillside’s 2019 EBIT calculation, using the version two formula:

$200,000 Net income + $30,000 interest expense + $40,000 tax expense = $270,000

EBIT presents a unique view of a company’s earnings that removes the impact of carrying debt, and the tax liability impact.

Why is EBIT important?

People who use the EBIT formula prefer to analyze a firm’s performance based on day-to-day business operations, and to disregard debt and tax rates. Hillside’s business operations include creating and delivering furniture products, purchasing inventory, paying employees, and billing customers.

EBIT can be used to compare a firm’s performance to other companies in the same industry. If you’re using EBIT for analysis, however, you need to understand how debt and taxes can differ between two companies.

EBIT and debt

A firm’s capital structure has a big impact on the amount of debt a business carries, and the interest expense on the debt.

Every business needs capital to operate, and companies raise capital by issuing stock or by borrowing money. Capital structure refers to the percentage of money raised by issuing stock or debt.

A startup firm without a history of predictable earnings may not be able to borrow money, and will raise capital using stock. Banks are willing to loan money to established firms that can repay debt using a consistent flow of earnings.

Hillside has a $500,000, 6% bank loan outstanding, which generates $30,000 in annual interest expense. Jane’s company has generated consistent earnings for the past 10 years, and Hillside’s bank relies on the stream of earnings to repay the loan.

Another factor is the amount of assets needed for a particular company to operate. Some industries, such as banks, must raise a large amount of capital to hire employees, invest in technology, and to operate physical bank locations. An online business may be able to operate with far less capital.

Hillside Manufacturing uses the bank loan to finance the machinery and equipment purchases, and to pay for repair and maintenance costs.

Firms with a small debt balance have less interest expense in the EBIT formula.

EBIT and taxes

Two companies in the same industry that generate similar profits can have very different levels of tax expense. The tax code is complex, and there are dozens of factors that impact a firm’s tax expense in a particular year.

For example, a tax carry forward allows businesses to reduce current year earnings with losses incurred in past years. If a business uses a tax carry forward, it lowers the tax expense in the current year. As a result, the current year EBIT is lower.

Hillside’s 2019 EBIT totaled $270,000, which includes a $40,000 tax expense on 2019 net income. Standard Manufacturing competes with Hillside’s in the furniture manufacturing industry.

Standard’s 2019 EBIT calculation includes a $10,000 tax expense and net income of $300,000. Standard’s tax expense is much lower than Hillside’s, even though Standard generated more net income ($300,000 vs. $200,000). However, Standard’s lower tax expense is due to a tax loss carry forward from a loss in 2018.

To get a true picture of EBIT for comparison purposes, review the income statement, balance sheet, and the footnotes to the financial statements. Hillside’s loan balance is recorded as long-term debt in the balance sheet, and Standard’s tax loss carry forward is reported in the financial statement footnotes.

It’s important to do your homework, so that your EBIT analysis is based on accurate information.

How to Use EBIT

Version two of the EBIT formula is the easier tool for performing analysis. Use these steps to review financial results using EBIT.

  1. Confirm the company’s net income in the income statement
  2. Find the tax expense and interest expense in the income statement
  3. Calculate EBIT using version two
  4. Review the balance sheet, income statement and the financial statement footnotes for additional information that impacts EBIT
  5. Use EBIT to compare a firm’s performance to industry benchmarks, or to the performance of other companies

Net income and cash flow are two different calculations, and these differences impact how EBIT is used in financial analysis.

EBIT and Cash Flow

Generally accepted accounting principles (GAAP) require companies to use the accrual basis of accounting to generate financial statements. Using the accrual method can result in large differences between EBIT and cash flow.

How accrual accounting works

The accrual method requires firms to recognize revenue when earned, and expenses when they are incurred to generate revenue. Cash inflows and outflows are not used to determine revenue, expenses, or net income.

Assume that Hillside purchases $1,000 in materials in January and pays labor costs of $2,000 in February to produce a piece of furniture. The finished product was delivered to a customer in early March and sold for $4,200.

Accrual accounting requires Hillside to post the $4,200 in revenue and $3,000 in material and labor costs in March. Assume that Hillside incurs other costs, including shipping, and that the profit on the sale was $700.

This approach matches expenses and revenue in the same period, and presents a more accurate picture of the profit.

How net income and cash flow are different

If you use the accrual basis to calculate net income, EBIT will not reveal information about cash inflows and outflows.

The furniture sale discussed above does not explain when cash was paid for the material and labor costs, or when the customer paid cash for the purchase. Hillside earned a $700 profit, but the data provided does not explain the firm’s cash inflows and outflows.

EBIT is a useful tool to analyze profit, but not cash flows. To understand a firm’s cash position, review the statement of cash flows.

EBIT vs. Operating Income: What is the Difference?

EBIT and operating income are two different calculations. To understand the differences, you need to review operating income and non-operating income.
Let’s use version two of the EBIT formula:

Net income + interest expense + tax expense

As explained above, net income is calculated as revenue less expenses. Businesses generate net income through operating income and non-operating income.

 

  • Operating Income: Income produced from day-to-day business operations. Hillside produces and sells furniture to generate operating income.
  • Non-operating Income: Income that is not related to a firm’s normal business operations. If Hillside sells a piece of equipment for a gain, the transaction produces non-operating income.

A business should generate the vast majority of net income from operating activities. Non-operating income is not sustainable, and should not be the primary source of business profits.

The net income balance in the EBIT formula includes both operating income and non-operating income.

What is a Good EBIT Margin?

To determine if an EBIT balance is attractive, consider the trend of a company’s EBIT over time, and how the balance compares with industry benchmarks.

A well-managed company can increase EBIT over time.

If the balance is increasing from year-to-year, the business is increasing sales and controlling costs, and the trend makes the firm more valuable.

You can also assess a company’s EBIT by comparing the balance to similar firms, or to industry benchmarks. Assume that Hillsides’s 2019 EBIT of $270,000 is 10% of annual revenue. If furniture manufacturing firms typically generate an EBIT totaling 7% of revenue, Hillside is performing better than others in the industry.

Potential buyers use EBIT when they consider the price they’re willing to offer for a company purchase. If a business generates a high EBIT, the owner can take distribution of earnings as a dividend. If two firms generate sales of $3 million a year, the company with the higher EBIT is more valuable.

Pros and Cons of EBIT

EBIT is frequently used as a tool for analysis, but there are pros and cons to the EBIT formula.

EBIT benefits

EBIT focuses on the earnings produced from a company’s daily operations. If management can improve the day-to-day operating results, EBIT increases and the firm is more valuable.

Every business that produces an income statement can generate the EBIT formula, which is why the calculation is used so often.

EBIT disadvantages

The tax code is complex, and the tax expense listed by one company may not be easily compared with another firm. In addition, EBIT does not address cash flow, and if the business is generating sufficient cash flows to operate moving forward.

The EBITDA formula adds back two other expenses to net income.

What is the Difference Between EBIT and EBITDA?

EBITDA is defined as earnings before interest, taxes, depreciation, and amortization is an accounting. EBIT does not add back depreciation expense and amortization expense to the net income total.

Businesses use assets to produce revenue, and depreciation expense is posted as tangible (physical) assets are used up. Hillside, for example, owns a $10,000 machine with a useful life of 15 years, The machine’s cost is reclassified to depreciation expense as the machine is used to produce revenue.

In a similar way, amortization expense is posted when an intangible asset is used in the business. Let’s assume that Hillside purchases a patent on a manufacturing process, and the patent has a remaining life of 20 years. Hillside will reclassify the cost of the patent to amortization expense over 20 years.

Both EBIT and EBITDA add back interest expense and tax expense to net income. EBITDA also adds back depreciation expense and amortization expense.

Which is Bigger, EBIT or EBITDA?

EBITDA adds back more expenses to net income, and EBITDA will have a larger balance than EBIT, if a firm owns tangible or intangible assets. While some firms may not own intangible assets, almost every business owns tangible assets that depreciate.

So, where do you go from here?

What to do Next

When you produce your financial statements each month and year, generate the EBIT balance. Compare the balance to past periods, and determine if the trend is increasing or decreasing.

Compare your firm’s performance to other companies in your industry. Use the right small business software will help you perform more detailed analysis in less time. QuickBooks has a built in feature that will allow you to run reports, track cash flow, manage inventory and payroll, and more. Try it free today!

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Next: What is Bad Debt Expense?>>

Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.

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