EBIT and EBITDA.
At a quick glance, you may not even notice the difference. While these two acronyms have many similarities, they function in slightly different ways. EBIT and EBITDA are metrics used to measure a firm’s profits. So, if you are a stockholder, chances are you have at least heard of these terms before. However, if you are new to the world of finance, these may be entirely foreign concepts.
We are going to cover the definitions of EBIT and EBITDA, what they are used for, and how they differ from each other. Stockholder or not, familiarizing yourself with financial lingo is invaluable to navigating the business world. After reading this article, you’ll know exactly what EBIT and EBITDA mean when you come across them on a quarterly report.
What is EBITDA?
EBITDA (operating profit) is a proxy for determining the success of a company by measuring its cash flow. EBITDA stands for Earnings Before Interest payments, Taxes, Depreciation, and Amortization.
So basically, it’s the amount of total revenue a company has before they’ve paid off their operating expenses. However, some of these terms may stump you even further. Before we move on, let’s quickly review what each of these terms means.
Interest is a fee for borrowing money from a lender. When a company takes out a business loan, they are required to pay back the amount they borrowed over time, which is called the principal.
Additionally, they are also required to pay back an additional percentage of that principal in the form of interest.
If you are a US citizen, chances are you are no stranger to taxes. Additionally, businesses have to pay corporate taxes of their own.
Corporate taxes are a tax placed on the taxable income of a corporation. So basically, companies pay the government a percentage of the income they make after their expenses have been paid.
Depreciation and Amortization
Depreciation allows a company to write off various assets over an extended period of time. As a result, depreciation allows companies to spread out the cost of very expensive assets like machinery or buildings and boost net income by only expensing a portion of the cost of the item. Depreciation occurs throughout the usable life of a particular asset.
Amortization is similar to depreciation; however, it is applicable to loans rather than purchasing assets. Amortization is a form of accounting that lowers the value of a loan over time. Essentially, amortization is depreciation for intangible assets.
When Is EBITDA Used?
Primarily, EBITDA is used by businesses looking to prove their long-term growth potential to potential investors. Furthermore, it is also a tool to compare the financial success of similar businesses against each other. So, if you’re looking to sell your business, for instance, calculating your EBITDA will help you accurately determine the valuation of your business.
Calculating EBITDA originated in the 1980s, while leveraged buyouts were extremely popular. Leveraged buyouts are when a company is purchased using largely borrowed money. Because of this, it became important for investors to know that the business they purchased would make enough to pay back the cost of acquisition. One form of measuring this was EBITDA.
Nowadays, EBITDA is more commonly used as a way for lenders to determine a business’s debt service coverage ratio, which, similar to its use for leveraged buyouts, allows lenders to assess whether a business will be able to pay back its debts.
How to Calculate EBITDA
Calculating EBITDA can be done with one of these simple equations, the first of which is as follows:
EBITDA = Revenue – Expenses (excluding tax, interest, depreciation and amortization)
Essentially, this means that the EBITDA formula is really just your net income, with the addition of taxes, interest, depreciation, and amortization.
Because of this, you can also calculate EBITDA starting with your net income, which will look like this:
EBITDA = Net income + Taxes + Depreciation + Amortization + Interest
To further clarify, let’s take a look at an example. Imagine that Jerry owns a hugely successful T-Shirt company and is looking to sell. In order to appeal to investors, we want to calculate his EBITDA. Jerry’s company has the following financial information:
- Net income: $1 million
- Interest paid: $200,000
- Depreciation: $150,000
- Amortization: $0
- Taxes paid:$130,000
The equation that Jerry would solve to arrive at his companies EBITDA would be:
With an EBITDA of $1,480,000
What Is EBIT?
Quite simply, EBIT (also known as operating income) is an acronym for Earnings Before Interest and Taxes and is highly valuable to a company’s ability to value its business operations. In other words, this acronym refers to a company’s net income before taxes and interest expenses are deducted. It’s one of the last before your income statement is reported. EBIT is extremely similar to EBITDA; however, it excludes depreciation and amortization.
This means that depreciation and amortization are taken into consideration when establishing a company’s financial worth. EBIT is an important tool for analyzing a business’s core operations net income by excluding tax expenses and their impact on overall profitability.
How Do You Calculate EBIT?
In order to calculate your company’s EBIT, plug in your overall revenue value and deduct the COGS or cost of goods and operating expenses from the revenue. The equation is as follows:
EBIT = Revenue – COGS – Operating Expenses
Various operating expenses include but are not limited to:
- Funds allocated for research and development.
Additionally, revenue is the income of a company, while the cost of goods sold is the overall value of goods that are sold during a particular period.
EBIT For Business Owners
Similarly to EBITDA, the main reason EBIT is useful for a company’s success is that it helps to quantify a company’s ability to generate enough earnings to make a profit, pay off debt, and continue to fund upcoming operations. You must calculate your company’s EBIT on a quarterly basis to ensure profit is being made to stay afloat.
Companies will also use EBIT as a way to appeal to future investors hopefully. Every business hopes to increase its earnings per share, so having a positive EBIT can be a great selling point.
EBIT for Investors
You might find yourself thinking: I am not a business owner, so why should I care? Well, if you plan on making investments into a certain business or a number of similar businesses, EBIT is an extremely powerful tool for comparing companies with different tax situations.
More specifically, some investors will use EBIT to see if a company has recently received a tax break, further increasing the company’s net income. EBIT can also help identify if there has been a cut in corporate taxes in the United States.
The main difference between EBITDA and EBIT is that EBITDA adds back in depreciation and amortization. As a result, EBIT paints a more realistic picture of a company’s generated income, while EBITDA is a better representation of cash flow. Additionally, EBIT is used to calculate interest coverage ratios, which determines how easily a company can pay back interest specifically on a debt.
EBITDA is better for companies with large amounts of fixed assets. Before depreciation, large asset purchases can make a company appear as if they have negative cash flow. Depreciation allows the business to list the asset as being paid throughout its usable lifetime rather than all at once.
One negative of EBITDA however, is that it can easily be skewed to create unrealistic projections for companies. A positive EBITDA is not a surefire way to determine whether or not a company is healthy. This is because taxes and interest are actual expenses that companies have to pay, and depreciation schedules can be manipulated to increase profit projections.
Final Thoughts on EBITDA vs EBIT
After all of this, you may be wondering which metric is best. However, there really isn’t a best metric as they are applicable for different things. Furthermore, when valuing a company, more than one metric should be used. In addition to EBITDA or EBIT, one should also consider things like revenue, net income, and FCF, meaning free cash flow.
It’s important to note that neither EBITDA nor EBIT is included on companies’ official income or cash flow statements. Furthermore, when looking to invest in a company, it’s recommended to speak with a financial advisor to make sure that your valuations are accurate.
Another way to assess the risk involved in investing in a company in addition to EBITDA or EBIT is by calculating a business’s debt to equity ratio. This is done by dividing a company’s debts by the shareholder’s equity. No matter what approach you take, when investing, it’s important to do thorough research to ensure that your investment is worth your while.