Earnings before interest and taxes (often called EBIT) is a funny term but is a very commonly cited accounting metric in business. The EBIT formula is used to determine and analyze a company’s profitability. EBIT is sometimes referred to as operating earnings or operating profit. Essentially, EBIT is a great way to look at the profitability health of a company. EBIT is often used for valuation purposes when attempting to determine the valuation of a company for investment or acquisition purposes.
What is the EBIT Formula?
There are a few different ways to do the EBIT formula, though, in one sense, they all refer to the same thing. Here are the main ways the EBIT formula is typically utilized:
EBIT = Net Income + Interest + Taxes
The above formula is the most commonly used EBIT formula as it tends to match exactly what EBIT stands for. It is essentially the earnings or net income of a company with the interest and taxes added back into it.
However, sometimes you’ll see the EBIT formula used this way as well:
EBIT = Revenue – Cost of Goods Sold – Operating Expenses
The two formulas differ in that one is more of a top-down calculation and the other is a bottom-up calculation. If you’re starting with revenue and subtracting the CoGS and operating expenses, then you’re going with a top-down approach. If you’re starting with net income and adding back in interest and taxes, then you’re going with a bottom-up approach.
EBIT Formula: Understanding the why behind it
Why is earnings before interest and taxes (EBIT) an important metric in business and accounting? Let’s dig into it further so that you can fully understand why you should be calculating EBIT for a given business.
EBIT is a snapshot of operating profitability. When you take the net income of a company and add back in interest and taxes, you are essentially ignoring interest and taxes. We want to sometimes ignore interest and taxes because it allows us to look at a company’s ability to generate earnings or profits from operations. By focusing on operational profits, we can then analyze the company’s operations more clearly and understand potential growth, understand the company’s ability to pay down debt and more.
EBIT is quite useful in comparing companies as well. While companies might have different tax burdens due to business structure or geographical location and while companies may have different capital structures, EBIT will let us ignore those two elements and do a more apples-to-apples comparison of the two companies’ operations. Companies that have high levels of debt will typically have heavy interest payments. By ignoring interest payments, we can better compare multiple companies and their abilities to generate profits. While debt levels obviously matter when evaluating companies for investment and acquisition purposes, sometimes getting a more clear look at operational profits is important and the EBIT formula is especially useful for just that.
EBIT Formula: Limitations of EBIT
One of the main limitations of using EBIT is the fact that depreciation is included in the EBIT calculation. Depreciation is a non-cash expense that a company records often with respect to its fixed assets. So, if we are comparing companies and one has a large deal of fixed assets such as real estate, factories and equipment, then they will usually also have a large depreciation expense. If we’re comparing that company with a company with very few fixed assets, then it can throw off the comparison a bit. EBITDA (earnings before interest, taxes, depreciation and amortization) is another formula option that attempts to remove depreciation from the equation just like EBIT removes interest and taxes from the equation.
Is EBITDA a better formula to use for understanding a business? Many analysts typically have their favorite and can rationalize why they prefer one or the other. In reality, it can be useful to use both to get a more complete picture. However, Harvard Business Review has some good insights into why EBITDA can be a bit misleading:
Depreciation and amortization are unique expenses. First, they are non-cash expenses — they are expenses related to assets that have already been purchased, so no cash is changing hands. Second, they are expenses that are subject to judgment or estimates — the charges are based on how long the underlying assets are projected to last, and are adjusted based on experience, projections, or, as some would argue, fraud.
Additionally, since interest expense is removed, if we’re using EBIT to determine profit potential, companies with a lot of debt can perhaps have exaggerated earnings potential since we’re not considering the consequence of the debt service (interest payments).
What does this mean? Well as with any kind of strong analysis in business and investing, EBIT is just one tool. To get a complete picture of a company, analysts have to use multiple formulas and tools to analyze a company from a variety of angles.
EBIT Formula Example
In order to better understand EBIT and how to use the EBIT formula, let’s look at a fictional example.
Jim’s Bike Shop is a company that sells and services bicycles. They own a few shops in town and generally speaking have had a solid business for a long time. Last year’s financials report the following information:
- Sales: $2,500,000
- Cost of Goods Sold (CoGS): $1,750,000
- Gross Profit: $750,000
- Operating Expenses: $300,000
- Interest Expense: $50,000
- Income Taxes: $50,000
- Net Income: $350,000
As we can see, the company had net income of $350,000, so let’s determine the earnings before interest and taxes using both the top-down and the bottom-up EBIT formula.
EBIT = Net Income + Interest + Taxes
EBIT = $350,000 + $50,000 + $50,000 = $450,000
EBIT = Revenue – Cost of Goods Sold – Operating Expenses
EBIT = $2,500,000 – $1,750,000 – $300,000 = $450,000
As we can see in both scenarios, EBIT is $450,000. This means that after cost of goods sold and other operating expenses (overhead) are taken care of, there is $450,000 left over to pay interest, taxes, pay down debt and distribute to shareholders.
The EBIT metric is pretty simple to calculate and tells us a lot about the company. Not only does it tell us about how profitable its operations are, it can help us answer some other questions as well. For instance, if the company is considering expanding or acquiring a competitor, the operational profit can tell us how risky it is to take on additional debt. If EBIT is healthy, taking on additional debt might not be a huge deal especially if the company can accurately project additional profits as a result of the expansion.
Looking at how a company is trending over time
Another important way to analyze a company is to examine how EBIT might be trending over time for a company. If a company has been increasing EBIT every year for five years, that is typically a great sign of a growing and healthy business. However, there are a few things that have to be considered in order to verify just how healthy and growing the company is.
Let’s first explore what might be the most positive ways a company might grow EBIT. The obvious one is to grow sales, but a company can grow sales while actually decreasing EBIT. For example, if a company doubles its overhead and increases sales by 25%, there’s a good chance that operational profitability will actually go down. The best examples of increasing sales and increasing EBIT at the same time are companies with operational leverage.
Operational leverage typically refers to companies that have high margins and low variable costs. This is most commonly seen in the software world where a company might have high overhead with employees, but can increase sales over time without increasing that overhead. Software has very low or zero marginal costs (a digital product doesn’t have to be produced compared to say how an automobile has to be produced each time).
While an automobile manufacturing company is a bit of the opposite from the high operational leverage companies in the world of software (producing more cars means creating more factories), it doesn’t mean automobile companies can’t increase sales and EBIT at the same time.
Other things can move sales and EBIT upward in addition to high operational leverage. For instance, increasing brand power, an effective marketing campaign and a new supplier which reduces component costs are all ways lower operational leverage companies can increase sales and EBIT.
Are there ways that a company can increase EBIT that might be red flags? The answer is definitely yes. The most common way is to increase debt. A company can achieve extraordinary growth in revenues and EBIT by taking on a bunch of debt. Perhaps, the debt is used to finance a series of acquisitions or build a number of new factories. If EBIT is increasing and debt has been increasing as well, it doesn’t necessarily mean the company is reckless. It just means that more analysis is required. Ensure that the debt levels can be safely covered by operations and cash flow.
Lastly, EBIT can sometimes be inflated or need further analysis when companies account for costs in various ways. Netflix is an interesting example of this in the way they account for content spending. Netflix spends vast sums of money on new content to be produced for its service and since going to original, company-owned content (versus licensed content), it requires Netflix to spend much more upfront. So, Netflix might allocate billions in cash in one year on content spending, but then amortize those costs over a period of several years. The following chart shows the differences here:
As you can see, in 2019, Netflix spent nearly $15 billion in cash on new content, but only recognized $9.2 billion in expenses for content spending in that given year. This can result in higher EBIT potentially. Is this weird or shady? Not necessarily. Netflix communicates why and how it amortizes content spend, and it isn’t abnormal to recognize different costs from cash spend. Netflix recognizes the full cost of content over the “lifespan” of the content. So, if Netflix believes a movie it creates has a useful lifespan of three years, it will recognize the expense over those three years.
Again, this shows why it’s important to use other metrics when evaluating a company in conjunction with the EBIT formula. For this example, cash flow statements are often analyzed intensely when analyzing Netflix because they spend so much upfront cash on content in a given year. Note: Moreover, Netflix has been financing this content spend with debt, so there are many variables to examine.
Earnings before income and taxes is a great tool to analyze a company’s profitability and health of operations. Depending on the data at hand, you can determine which EBIT formula to use. Then, as you wish to get a more fuller picture of a company you’re analyzing, consider looking at things such as debt levels, depreciation expenses and how the company is trending over time.