EBIT Meaning

  • It only shows the amount of profit the company generates from its operating activities.Here, the interest and taxes expenses are not considered for calculating the EBIT as they do not arise due to the operating activities, which means operating profit or operating earningsOperating EarningsOperating Earnings is the amount of profit a company earns after deducting direct and indirect costs from sales revenue. It is also referred to as EBIT, which stands for profits before interest and taxes.read more.

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Components of Earnings Before Interest and Tax

#1 – Revenue

Revenue is the main source of income in the business, which is generated from the sale of goods and services during its normal business.

#2 – Cost of Goods Sold (COGS)

The cost of goods soldCost Of Goods SoldThe Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. read more refers to the direct cost incurred in producing finished goods and selling services. This includes the purchase cost of raw materials, direct labor, and other overhead expenses. The COGS formula for the cost of goods sold is:

COGS = Opening inventory + purchases of raw material + direct labor + overheads – closing inventory

#3 – Operating Expenses

Operating expenses are expenses incurred by the business in the normal course of its operations. It includes selling, general and administrative expensesSelling, General And Administrative ExpensesSelling, general and administrative (SG&A) expense includes all the expenses incurred in the selling of the products of the company whether direct or indirect along with the entire general and the administrative expenses during an accounting period under consideration such as advertisement expenses, sales promotion expenses, marketing salaries, etc.read more like rent, salary to administrative staff, traveling expenses, etc.

EBIT Formula

It can be calculated by using direct and indirect methods.

#1 – Direct Method

Earnings Before Interest and Tax = Revenue – Cost of goods sold – Operating Expenses

This EBIT formula for the direct method deducts the associated expenses directly from the revenue generated.

#2 – Indirect Method

Earnings Before Interest and Tax = Net income + Interest expenses + Tax expense

EBIT Examples

Example #1

We have a company named ABC Inc., having revenue of $4,000, COGS of $1,500, and operating expenses of $200.

EBIT directly deducts the cost incurredThe Cost IncurredIncurred Cost refers to an expense that a Company needs to pay in exchange for the usage of a service, product, or asset. This might include direct, indirect, production, operating, & distribution charges incurred for business operations. read more from the earnings, whereas the second equation adds back the interest and taxes as EBIT itself says that it is earnings before interest and taxes. This distinction is different as it allows the users to understand the concept of EBITfrom two perspectives.

The first is to see EBIT from a preliminary operations perspective, while the other is to see it from a year-end profitability perspective. Although both the equations will derive the same number, analyzing the number from a different perspective is important from the investors’ point of view.

If interest is the main source of income of the business-like in the case of banks and financial institutions, then such interest income is to be included in the Earnings Before Interest and Tax.

Example #2

Let’s take an example of Harry Corporation, which has the manufacturing business of Gadgets. The income statementIncome StatementThe income statement is one of the company’s financial reports that summarizes all of the company’s revenues and expenses over time in order to determine the company’s profit or loss and measure its business activity over time based on user requirements.read more of Harry Corporation reported the following activities.

  • Revenue from operations: $2,500,000COGS: $1,400,000Operating Expenses:$400,000Interest Expense: $200,000Tax Expense: $30,000

Now from the below figures, we can calculate gross profit (Revenue – COGS)

= $2,500,000 – $550,000

Gross Profit = $1,100,000

And net income formulaNet Income FormulaNet Income formula is calculated by deducting direct and indirect expenses from the total revenue of a business.. It is the most important number for the Company, analysts, investors, and shareholders of the Company as it measures the profit earned by the Company over a period of time.read more = Gross profit – Operating Expense – Interest expense – tax expense

= $1,100,000 – $400,000 – $200,000 – $30,000

Net Income = $470,000

Now we need to calculate Earnings Before Interest and Tax from the two equations:

= $2,500,000 – $1,400,000- $400,000 = $700,000

= $470,000 + $200,000 + $30,000 = $700,000

Advantages

  • It can give a clue about the company’s earning potential. It is a crucial figure which attracts potential buyers and investors. Through the figure of EBIT, investors can analyze the return they can earn from the investment in the company.The investors and creditors use EBIT as it helps them to know about the success of the business’s core operations without worrying about the tax implications and the company’s cost of the capital structure. Moreover, they can simply check whether the activities of the business and their ideas are working in the real world or not.Compared to the other financial ratios, earnings before interest and taxes are easy to calculate and simple to understand. So as a user, the first figure which provides a basic understanding of the company is EBIT.

Limitation

  • DepreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year.
  • read more is considered while calculating the EBIT. While comparing the results of different industries, depreciation variations in the result will be there. For example, if the person is comparing earnings before interest and taxes of a company having a significant amount of the fixed assets with that of the company having few fixed assets, then due to depreciation expenses company with fixed assets will have the fewer earnings before interest and taxes as the expense leads to the reduction in the net income or the profit.Companies with a large portion of finance through debt will surely have a huge interest expenseInterest ExpenseInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense.read more. Earnings before interest and taxes do not consider such interest expense resulting in the inflation of the company’s earning potential. Non-consideration of the interest expense may misguide the investors as there is a possibility that due to the poor sales performance or the decreased cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more, the company has taken huge loans. But EBIT fails to get the attention of the investors towards such high debts.

Importance

  • It is important to set an industry standard as a benchmark while comparing any financial metric of two companies. Simply comparing the operating profits of two companies is not enough as it doesn’t tell the investor about the company’s earning potential compared to the other companies working in the same industry.Also, it is necessary to create trends while evaluating the potential earning companies and comparing prior years with the current year to check if there exists a trend.

Conclusion

Earnings before interest and taxes measure the firm’s profit from its operations. The use of earnings before interest and taxes is not limited to its calculation. Still, it is also used as input while calculating financial ratiosCalculating Financial RatiosFinancial ratios are indications of a company’s financial performance. There are several forms of financial ratios that indicate the company’s results, financial risks, and operational efficiency, such as the liquidity ratio, asset turnover ratio, operating profitability ratios, business risk ratios, financial risk ratio, stability ratios, and so on.read more like operating margin, interest coverage, etc. Also, to calculate the degrees of various leverages, we need to calculate EBIT.

This has guided what EBIT is, its meaning, and its formula. Here we discuss how to calculate Earnings Before Interest and Tax along with practical examples. You may learn more about accounting from the following articles –

  • Calculation of EBITDAEBIT MarginEBITDA CalculationEBIT vs EBITDA