Earnings before interest and taxes (EBIT) is a common financial metric used to assess a company’s operating profitability. Because it excludes some non-operating income and costs such as interest and taxes, EBIT can be used to provide a picture of a company’s underlying business performance and ability to generate profits from sales.
What Is Earnings Before Interest and Taxes (EBIT)?
EBIT is a company’s net income excluding interest payments and income taxes — a company’s net income excluding interest payments and income taxes. EBIT is a useful metric for business managers who want to monitor their company's ability to earn enough to deliver profits for business owners, pay down debt and fund ongoing operations.
- EBIT is a key measure of a company’s operating profitability.
- EBIT is a company’s net income excluding interest payments and income taxes.
- Because it excludes interest and taxes, examining EBIT can provide a clearer picture of underlying business performance than looking at net income.
- However, EBIT can be a misleading indicator for highly indebted companies or those with large amounts of fixed assets.
- EBIT is easily calculated from a company’s income statement.
- There are two ways to calculate EBIT: top down and bottom up. The two methods can produce different results in some cases.
- The top-down method illustrates business performance for companies with complex operating structures, but the bottom-up method can be simpler to use for smaller companies.
As a financial metric, it’s somewhat similar to company’s operating income, and the two terms are sometimes used interchangeably. However, EBIT differs from operating income because it can include income and expenses from non-operational sources, such as depreciation and restructuring costs. EBIT can be used to analyze a company’s underlying profitability without the effects of capital structure (proportions of debt and equity) and tax arrangements.
Why Is EBIT Important?
EBIT is an important metric for company managers, as well as investors and potential lenders — although it’s not one of the indicators featured in generally accepted accounting principles (GAAP). It’s a key measure of the company’s ability to generate profits from sales. It also forms the basis of key lending measures such as the interest coverage ratio (as I’ll discuss later). Some companies report EBIT as a key performance indicator. But even if a company doesn’t report EBIT, it can be calculated from the company’s income statement.
EBIT Formula and Calculations
There are two ways of calculating EBIT: top down and bottom up. The top-down method starts with the company’s net income, as shown on its income statement, and adds back interest and taxes paid:
EBIT = net income + interest + taxes
EBIT = revenue - COGS - operating expenses
In many cases, these two calculation methods will yield the same result. However, the methods will give different results if the company’s net income includes income that doesn’t come from sales and/or if it includes expenses that aren’t operating expenses.
Here’s an example of using EBIT to measure profitability. Suppose a business’s income statement includes the following information:
Calculating EBIT using the “top-down” approach:
EBIT = $110,000 + $50,000 + $70,000 = $230,000
Calculating EBIT using the “bottom-up” approach:
EBIT = $1,200,000 – $850,000 – $120,000 = $230,000
In this example, the two calculations give the same result, because the company doesn’t have any income that’s not derived from sales, or any expenses that aren’t operating expenses (besides tax and interest).
But suppose the company has been going through a restructuring. It sold a business line that was performing well but wasn’t core to its business, and it has called in consultants to help it redesign the rest of its business. The income statement would look like this:
Calculating EBIT using the top-down approach gives the following result:
EBIT = 90,000 + 50,000 + 70,000 = $210,000
But calculating EBIT using the bottom-up approach gives the following:
EBIT = 1,200,000 – 850,000 – 120,000 = $230,000
In this case, the top-down method of calculating EBIT gives a different result from the bottom-up method, because it captures the non-operating expenses related to the company’s restructuring. The difference between the two calculations represents the $20,000 net loss due to the restructuring: a $40,000 gain from the asset sale minus $60,000 in restructuring expenses.
For this reason, the top-down method is sometimes used to analyze business performance for larger companies with complex operating structures. However, for smaller companies and startups with simpler structures, the bottom-up method can be simpler to use.
EBIT and Taxes
Removing taxes from a key profitability metric may seem odd, since, as Benjamin Franklin is alleged to have said, “in this world nothing is certain except death and taxes.” But business taxes are not applied in the period in which they are incurred. Losses in one period can result in tax credits that the company can carry forward into subsequent periods, sometimes for many years. Additionally, tax law is subject to change without much notice, so it’s possible for companies to report worse or better bottom line profits relative to previous years simply because of tax changes. So, excluding the effect of taxes on reported profits can give company managers a clearer indication of business performance year-on-year.
Removing taxes from business performance metrics is also useful when comparing companies in different countries, or even in different states, since tax rates can differ considerably between jurisdictions.
EBIT and Debt
Removing the effect of debt from a company’s key performance metric can be useful when the company has taken on debt to invest for the future. The business’ operating profit can start to reap the benefit of the extra investment even though the cost of debt service is depressing bottom line profits. This will show up as improving EBIT.
Companies can have very different capital structures, and this can make their net income look very different even if the underlying businesses are similar. Managers can use EBIT to compare their own business’ underlying performance with that of similar businesses that have different capital structures. This can be a better indicator of business competitiveness than straightforward comparison of net income.
EBIT can be a better metric than net income when a company is highly indebted. For example, suppose a business has an income statement that looks like this:
Calculating EBIT by either of the two methods discussed above shows us that although the company has made a loss, it is entirely due to its very high debt service costs:
EBIT = (120,000) + 300,000 + 50,000 = $230,000
EBIT = 1,200,000 – 850,000 – 120,000 = $230,000
The underlying business is profitable. Depending on the circumstances, therefore, resolving this company’s financial problems might involve debt restructuring, a cost-cutting drive and/or asset sales.
A key metric often used by business managers and lenders to determine how much debt a company can handle is the interest coverage ratio (ICR). This is calculated as:
ICR = EBIT / interest expense
The ICR shows the proportion of the company’s pre-tax earnings that will be taken up in debt service. The higher this proportion, the more likely it is that the company will have difficulty paying its debts. An ICR of 1.5 or less is often considered to indicate debt distress. In the example above, the ICR is $230,0000/$300,000 = 0.767, which means the company is not earning enough to cover its debts.
However, it can be important to monitor the ICR over a period of time, rather than making decisions based on one period alone. Companies can experience considerable volatility in net income without necessarily being insolvent. Suppose this company normally has sales revenue around $1,500,000 and cost of sales $750,000 but has been affected by an unusual adverse weather event that has temporarily disrupted its supply chains and its customers’ operations, causing sales to drop and cost of sales to rise. Calculating EBIT using the bottom-up method gives EBIT of $630,000 and a healthy ICR of 2.1.
EBIT vs EBITDA
Earnings before interest, taxes, depreciation and amortization (EBITDA) is an operating profit metric that’s somewhat similar to EBIT. However, as its name suggests, it differs from EBIT in that it also excludes depreciation and amortization of fixed assets such as buildings and equipment. Because of this, EBITDA can give a more favourable impression of the company’s operating profit than EBIT, particularly if a company has substantial fixed assets.
Advantages and Limitations of EBIT
Companies with substantial fixed assets may have a distorted view of company performance using EBIT, because it includes depreciation and amortization. EBIT can also be a misleading metric for highly leveraged companies. Consider two companies that have similar operating profits, but one has much larger debts than the other. The more highly indebted company has higher debt service costs and lower net income for that reason and is therefore more likely to be unable to pay its debts. Comparing the EBIT of the two companies can give a false impression that the two are equally financially sound.
Finally, EBIT doesn’t measure cash flow. It’s possible for a company to have positive EBIT but negative cash flow from operations. Companies can fold due to lack of free cash even if they are profitable by other measures, particularly if they are highly indebted.
But even taking into consideration some of its limitations, EBIT is a useful metric for business managers who want to monitor their company's ability to earn enough to deliver profits for business owners, pay down debt and fund ongoing operations — particularly when viewing it using accounting software with comprehensive dashboards. It’s also useful for investors and lenders, since it focuses attention on the business’s operating profitability and provides a useful rule-of-thumb for assessing the company’s ability to pay its debts.