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February 7, 2022
As a startup founder, it’s common to come across finance and accounting terms you’re expected to know, but have a limited understanding of.
One term that leaves many entrepreneurs confused is EBIT—earnings before interest and taxes (EBIT)—a commonly used indicator of a company’s profitability.
Below we’ll dive into what EBIT means, how to calculate it, its benefits and limitations, and ultimately what it means for your business.
As we mentioned above, EBIT is the acronym commonly used in the accounting world for earnings before interest and taxes. You may have also heard the terms operating profit and profit before interest and taxes in addition to earnings before interest and taxes—all are synonymous with EBIT. EBIT is also sometimes referred to as operating income due to the similarities between the two (namely, that both exclude the expenses of interest and taxes), but operating income is calculated slightly differently and will not always be identical. (More on that later).
By ignoring variables like a company’s tax burden and capital structure, EBIT generates a metric that places the focus exclusively on a business’s ability to generate income from its core operations, which it can use to fulfill debt obligations and finance future actions.
EBIT is also among a class of financial metrics known as KPIs—key performance indicators.
Now that we’ve answered the question, “What does EBIT mean?” let’s discuss ways to calculate it with the two main earnings before interest and taxes formulas.
The first method begins with the total revenue (or sales—the two are synonymous) value from the top of the income statement of the three basic financial statements. Subtract the cost of goods sold (COGS) from that value—the result will be gross profit. From that value, subtract operating expenses—the result will be EBIT. Here’s what this method looks like as a mathematical equation:
EBIT = Revenue – COGS – Operating Expenses
The second way to calculate EBIT begins with the net income value from the bottom of the income statement. From that value, add back the interest and taxes that have been subtracted above on the income statement. Here’s what this method looks like as a mathematical equation:
EBIT = Net Income + Interest + Taxes
There’s also a third way to calculate EBIT; however, it begins with the value of earnings before interest, taxes, depreciation, and amortization (EBITDA)— more on this later—which is usually calculated beginning with either EBIT itself or with net income. We’ve chosen not to include it because, in most cases, calculating EBIT beginning with EBITDA will essentially be working backward.
EBIT is a useful way for investors to compare the relative profitability of companies that may have significantly differing circumstances when it comes to taxes and debt.
First, let’s look at taxes.
With EBIT, investors are able to compare the profitability of multiple companies with varying tax situations. For instance, let’s consider a hypothetical in which an investor is considering purchasing stock in one of two companies: In this hypothetical, the two companies have made identical profits, but one of them received a substantial tax break in the past year and the other did not.
By looking only at net income, the companies appear equally profitable. EBIT, however, removes the portion of the profits resulting from the tax cut (which is unlikely to happen consistently and is therefore not indicative of future performance) from consideration. By considering the two companies using EBIT, it becomes apparent that the company that did not receive the tax cut made greater profits from their actual operations, whereas the other company’s profits were propped up by their tax savings.
Though it’s not a certainty, it is likely the company that made more profits from their core operations will be more profitable in the future and will therefore be the better investment.
Next, let’s take a look at how EBIT can be used with debt in mind, specifically when comparing companies in capital-intensive industries like energy, semiconductor manufacturing, and telecommunications.
In these industries, companies must possess greater amounts of fixed assets—long-term assets that cannot be easily converted into cash, like buildings, land, and machinery. These expensive assets are usually financed with debt and that large amount of debt results in significant amounts of interest expenses. This debt and the resulting interest—while it must be carefully managed—is a necessity for long-term growth and competitiveness in some industries.
In these industries, debt amounts can vary widely from company to company depending on how recently and how many/much profit-generating fixed assets a company has purchased, resulting in significantly different interest expenses. In these cases, it is entirely possible that companies with lower net income due to their interest expenses are more operationally profitable due to the profit-generating assets on which they’re paying interest.
Put simply, a company may sacrifice current profits for significantly greater future profits, which will make it a better long-term investment, and EBIT will reflect that.
Though EBIT can be a useful tool to assess a business’s profitability, especially from an investor standpoint, it is not a Generally Accepted Accounting Principles (GAAP) financial measure. For this reason, EBIT is not usually labeled as such in financial statements, though the exact same value may be included under the label “operating profits” on a company’s income statement.
The primary reason EBIT isn’t a GAAP financial measure is that there are sometimes exceptions in the way it’s calculated, which may have different results. For instance, you may exclude some unusual revenues and expenses (such as the revenue from the sale of a large asset or expenses incurred from a legal suit) from an EBIT calculation because they aren’t related to the business’s core operations. Because these exceptions are by their very nature irregular, there is no way to standardize them.
Additionally, some non-operating income that is expected to be earned regularly (investment income, for example) may—but does not have to be—included. This is also why EBIT is distinct from operating income.
Yes, while EBIT excludes interest and taxes, depreciation expenses and amortization expenses are included, which can sometimes lead to distortions similar to some of those which EBIT attempts to avoid, and brings us to EBITDA.
The solution to this problem is EBITDA—earnings before interest taxes, depreciation, and amortization. EBITDA also excludes interest and taxes from a comparison between multiple companies’ profitabilities, but it goes a step further by also excluding depreciation and amortization expenses.
Explained simply, depreciation and amortization are two methods of expensing the cost or value of business assets each year over the period of time the asset generates revenue. Like tax and interest, depreciation and amortization can significantly decrease net income. By excluding them in addition to interest and taxes, analysts can use EBITDA to get a clearer picture of a company’s ability to generate income solely from its core operations.
Because most startups operate at a loss, EBIT and EBITDA aren’t often used by investors’ and analysts’ assessment of a company’s valuation. Once a startup becomes cash flow positive, however, higher EBIT and EBITDA values generally correlate with higher valuations, so it’s important to be prepared for that moment with the knowledge we’ve outlined above.
Zeni is a new age, full-service finance firm for startups and small businesses, built from the ground up to give our customers all the advantages of cutting-edge AI and ML technology. Our team of seasoned financial experts can help you manage your startup’s finances all the way from pre-seed funding all the way to an eventual IPO or acquisition.