Earnings Before Interest and Tax

Definition of Earnings Before Interest and Tax (EBIT)

Earnings before interest and tax indicate the company’s operating profit before considering the amount of interest and taxes. It is used to evaluate the performance of the company’s main operations where the profit is not affected by the cost of capital is interest, and tax expense.

Explanation

EBIT refers to operating income which the company earns by conducting its operations. It means the net Income (Revenue-Expense) of the company to calculate which Tax expense and interest expense are not deducted.

The formula for Earnings Before Interest and Tax (EBIT)

Earnings before Interest and Taxes(EBIT) is calculated as follows:

It can also be calculated in other manner where:

Example of Earnings Before Interest and Tax (EBIT)

For Example, The income statement of XYZ Inc is as follows:

Compute the Earnings before interest and taxes.

Solution:

To calculate Earnings before Interest and Taxes, we have to deduct direct and indirect expenses from the Net revenue, excluding interest expense and tax expense. Other incomes are also included in the calculation of EBIT. So, the calculation of EBIT is as follows:

EBIT is calculated as

EBIT = Net Earnings +Income Taxes+ Interest Expenses

• EBIT = 602 + 3,500 + 425
• EBIT = $4,527

This shows that after bearing all the operating cost during the year out of the year’s income, a profit of $4,527 is left, which is available to pay off the expense regarding taxes ($3,500) and the cost of capital is interest($425).

EBIT and Net Profit

For the calculation of EBIT, interest expense and Tax Expenses has to be ignored. The government, shareholders or lenders use EBIT for analyzing the profitability of the company. It includes the deduction of operating expenses like Rent of office, Salary of employees, electricity bills, printing and stationary etc. So, before calculating the Net Profit of the company, a calculation of EBIT should be done. While the calculating Net profit of the company, the cost to operate a business, like interest expense, depreciation on assets and tax expenses, has to be deducted from Earnings before interest and Taxes. Net profit is used while calculating earnings per share of the company. The shareholders of the company commonly use this figure as dividend is distributed out of this profit. The relationship between EBIT and Net Profit is shown below:

Earnings Before Interest and Tax (EBIT) Analysis

EBIT is calculated in different ways, and it is not included in the company’s financial statements. It always starts with revenue from sales operation and subtracts direct and indirect expenses, excluding interest and tax expenses. Non operating incomes are also included in the calculation in some cases. Interest income is included or excluded from the calculation of EBIT based on its source. If credit is provided to the customer as a crucial portion of its business, then this income is treated as operating income and included in EBIT computation. If interest is received on investment or in the form of late fees from customers, it may not be included in EBIT computation. EBIT is also calculated in reverse order by taking Net profit after interest and taxes and added interest and tax expenses into it.

Importance of Earnings Before Interest and Tax (EBIT)

• It is important to calculate Earnings before interest and Taxes as it provides ideas to the owners about the profits generated by the company from its core operations without taking the cost of capital and income taxes into account.
• Net Profit can be calculated only after the calculation of Earnings before interest and taxes.
• The shareholders use the net profit for calculating their Earning per share.

Advantages of EBIT

Advantages are provided and discussed as below-

• With the help of Earnings before Interest and Taxes (EBIT), the investors can compare different companies under the same industry. For example, if an investor wants to purchase a share, the EBIT of different companies with different rate of taxes under the same industry can be compared to ascertain the base profitability of the companies because the tax rate may vary from company to company.
• Some industries require huge investments in fixed assets so that they can produce goods and services. To Finance, these investments companies have to raise debt. Companies under the same industry can raise debt based on their need. So, the amount of interest may vary from company to company. So to analyze the earning potential of the company, interest expense is excluded from operating income by the investor.
• EBIT is a more reliable source of comparison among different companies as it is not considering the effect of tax rates and interest expense which may vary from company to company.

Disadvantages of EBIT

Disadvantages are provided and discussed as below-

• As the calculation of EBIT includes the deduction of depreciation, sometimes it can lead to misleading results when different companies are compared under the same industry. For example: If an investor compares a company having a huge investment in fixed assets with other company having few fixed assets, the EBIT of the former company turn to be lower as depreciation expense reduces the profit of the former company.
• Some company raises a huge amount of debt due to its low performance or low cash flows that result in high-interest expense. As EBIT is not taking the deduction of interest expenses into account, this will enhance the earning of that company, and it misleads the investors.

Conclusion

Thus, EBIT is calculated by reducing operating expenses from the operating income before considering interest and tax expenses. It is calculated before the calculation of the final profit of the company. It is a more reliable source of comparing the profitability of the companies under the same industry than Net profit as taxes rate, and interest expense may vary from company to company.

Recommended Articles

This is a guide to Earnings Before Interest and Tax. Here we also discuss the definition and importance of earnings before interest and tax (EBIT) along with advantages and disadvantages. You may also have a look at the following articles to learn more –

1. Estimated Tax
2. Times Interest Earned Ratio
3. Interest vs Dividend
4. EBITDA vs Operating Income
5. Adjusted EBITDA