Earnings before interest and taxes (EBIT) and earnings before interest, taxes, depreciation and amortization (EBITDA) are two commonly used measures of business profitability. As their names suggest, there are similarities between the two metrics. EBIT is net income before interest and taxes are deducted; EBITDA is similar, but also excludes depreciation and amortization—in practice, EBIT measures a company’s ability to generate profit from its operations. Some investors are wary of using EBITDA to assess profitability because they believe it can give a misleading picture of a company’s financial health.
- EBIT and EBITDA are both measures of a business’s profitability.
- EBIT is net income before interest and taxes are deducted.
- EBITDA additionally excludes depreciation and amortization.
- EBIT is often used as a measure of operating profit; in some cases, it’s equal to the GAAP metric operating income.
- Companies in asset intensive industries often prefer EBITDA over EBIT.
- Neither EBIT nor EBITDA are GAAP metrics; some investors are particularly wary of EBITDA, because they believe it can give a misleading picture of a company’s financial health.
EBIT vs EBITDA
Both EBIT and EBITDA are measures of the profitability of a company’s core business operations. The key difference between EBIT and EBITDA is that EBIT deducts the cost of depreciation and amortization from net profit, whereas EBITDA does not. Depreciation and amortization are non-cash expenses related to the company’s assets. EBIT therefore includes some non-cash expenses, whereas EBITDA includes only cash expenses.
Neither EBIT nor EBITDA are approved metrics under U.S. Generally Accepted Accounting Principles (GAAP), a set of rules maintained by the Financial Accounting Standards Board (FASB). For this reason, public companies and others that must comply with GAAP cannot use EBIT or EBITDA to fulfil statutory reporting requirements, although they may choose to report them in addition to the GAAP-approved metrics.
What is EBIT?
Earnings before interest and taxes (EBIT) is a common measure of a company’s operating profitability. As its name suggests, EBIT is net income excluding the effect of debt interest and taxes. Both of these costs are real cash expenses, but they’re not directly generated by the company’s core business operations. By stripping out interest and taxes, EBIT reveals the underlying profitability of the business.
The information used to calculate EBIT is found on your income statement. Also known as a profit and loss statement, it’s a way to see your company’s expenses and revenues over a given time—usually three months. Tracking that information can be done with spreadsheets, but that can be time consuming, inaccurate and increasingly difficult as your business grows and matures. Even small businesses can benefit from accounting software to help track expenses. The best-in-class accounting solutions can also integrate seamlessly with other enterprise resource planning (ERP) solutions, such as payroll, human resources management and inventory management.
There are two ways to calculate EBIT. The first method starts with net income and adds back interest expenses and taxes paid or provisioned:
EBIT = Net income + interest expenses + taxes
EBIT = Sales revenue – COGS – operating expenses
EBIT calculated using the second method is always equal to operating income as defined under GAAP, but EBIT calculated using the first method differs from operating income if net income includes non-operating income and/or expenses.
EBIT is a measure of operating profit. This is true for both calculation methods. By eliminating the effect of interest and taxes, it shows the business’s underlying profitability regardless of the company’s capital structure or the tax jurisdiction where it operates. Business owners and managers can use EBIT to get a picture of their business’ competitiveness and its attractiveness to investors. Investors and analysts can use EBIT to compare companies in the same industrial sector that have different capital structures or operate in different tax jurisdictions.
However, because EBIT excludes the cost of servicing debt, it can give a misleading impression of a company’s financial resilience. A highly leveraged company could report the same EBIT as a company with very little debt, but the highly leveraged company might be more likely to fail if it suffered a sudden drop in sales.
EBIT is just one measure of your company’s financial health. But it, and other financial reports and metrics, rely on accurate and up-to-date data. Business accounting software helps you accurately report EBIT and other measures.
What is EBITDA?
Earnings before interest, taxes, depreciation and amortization is a measure of business profitability that excludes the effect of capital expenditure as well as capital structure and tax jurisdiction.
As its name suggests, EBITDA differs from EBIT by excluding depreciation and amortization. Depreciation and amortization are accounting techniques that spread the cost of an asset over several years, resulting in a recurring expense that is deducted from the company’s revenue each year. Depreciation is applied to fixed, tangible assets such as machinery, whereas amortization is used for intangibles such as patents. Depreciation and amortization are not cash expenses, and don’t affect a company’s liquidity. So, excluding depreciation and amortization can give business managers a comparison of their company’s performance with other companies in the same industry.
However, since it does not include movements in working capital, it is not equivalent to operating cash flow as defined under GAAP. Some companies report an adjusted EBITDA measure that also excludes a variety of one-off and exceptional items.
There are two widely used methods of calculating EBITDA. The first method starts with net income and adds back interest, taxes, depreciation and amortization:
EBITDA = Net income + interest expense + taxes + depreciation + amortization
If you’re calculating EBITDA from a company’s financial statements, you’ll find net income, interest expense and taxes on the income statement. Depreciation and amortization are sometimes listed separately as items on the income statement or on the cash flow statement. Alternatively, they may be bundled into operating expenses, in which case you can usually find them in a note accompanying the accounts.
The second method starts with EBIT, calculated using one of the two methods described earlier, and adds back depreciation and amortization. The formula is:
EBITDA = EBIT + depreciation + amortization
EBITDA strips out the cost of the company’s asset base as well as its financing costs and tax liability. By removing all non-operating expenses, EBITDA gives what some might see as a purer view of your business’s underlying profitability and can provide an indication of its ability to generate free cash from its operations.
EBITDA is especially useful as a profitability measure in asset-intensive industries where companies are often highly leveraged. For these companies, the annual depreciation/amortization and interest expenses associated with those assets can significantly reduce bottom-line profits.
However, because EBITDA excludes these costs, it can give a misleading impression of a company’s financial health. Interest and taxes are real business expenses that drain cash from a company. And although depreciation and amortization are accounting techniques rather than real cash outlays, many assets really do lose their value over time and eventually will have to be replaced. Thus, EBITDA may give the impression that a company’s expenses are lower than they really are, and therefore that it is more profitable than it really is.
Key Differences Between EBIT vs EBITDA?
|Excludes interest and taxes||Excludes interest, taxes, depreciation and amortization|
|Includes non-cash charges (depreciation and amortization)||Does not include non-cash charges|
|Measures your business’s profit from operations; often similar or equal to operating income|
|Widely reported, especially by highly leveraged companies with good operating profits||Often preferred as a profitability metric for companies that have large investments in fixed assets financed with debt|
|Can give a misleading impression of the company’s resilience to a fall in sales||Can give a misleading impression of the business’s general financial health|
Why Calculate Each One?
EBIT and EBITDA serve slightly different purposes. EBIT is a measure of operating income, whereas. Depending on the company’s characteristics, one or the other may be more useful. Often, using both measures helps to give a better picture of the company’s ability to generate income from its operations.
Example of EBIT vs EBITDA
Consider a company whose income and cash flow statements look like this:
|Cost of goods sold (COGS)||$800,000|
|Cash flow statement (first section)|
|Cash from operating activities|
|Less: depreciation and amortization||$70,000|
|Less: changes in working capital||$10,000|
|Cash from operations||$80,000|
The high interest expenses and depreciation/amortization costs reflect the fact that the company has a high level of debt and a significant base of assets that are depreciating over time.
Calculating EBIT from net income:
= Net income + tax paid + interest expense
= $160,000 + $50,000 + $70,000
Calculating EBIT from revenue:
= Sales revenue – COGS – operating expenses
= $1,200,000 - $800,000 - $120,000
The cash flow statement gives us the depreciation and amortization that aren’t shown separately on the income statement. So, calculating EBITDA:
= EBIT + depreciation & amortization
= $280,000 + $70,000
For this company, EBITDA is higher than EBIT, so the company might prefer to highlight EBITDA as a performance metric.
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Why Is EBITDA Preferred to EBIT?
EBITDA is often preferred over EBIT by companies that have invested heavily in tangible or intangible assets, and therefore have high annual depreciation or amortization costs. Those costs reduce EBIT as well as net income. These companies may prefer to use EBITDA, which is generally higher because it excludes these costs, as a better indicator of the underlying profitability of business operations.
EBITDA is also a popular metric for leveraged buyouts, in which an investor finances the acquisition of a company with debt. The investor then loads the debt onto the acquired company’s balance sheet and withdraws cash from the company to make interest payments on the debt. Because it can be used to estimate cash flow, EBITDA can provide some idea of whether the target company is capable of generating the cash needed to pay the interest on the debt.
What Does a Low EBIT but High EBITDA Indicate?
If your company has low EBIT but high EBITDA, it has high depreciation and/or amortization expenses. This means it likely has a large number of fixed assets and is gradually writing down the value of those assets over time.
Suppose a fast-growing company with substantial cash reserves is experiencing strong demand for its products. To meet demand, it buys additional production machinery. Because the company can pay for the machinery from its cash reserves, the purchase increases the company’s tangible asset base but doesn’t add any debt. IRS rules allow the company to depreciate the assets over five years. Over those five years, therefore, the company will have increased depreciation costs but low interest charges. EBIT excludes the interest charges but not depreciation, whereas EBITDA eliminates both. As a result, EBITDA will be higher than EBITDA.
EBITDA would also be higher than EBIT if the company acquired an intangible asset such as a patent and amortized the cost. However, intangible assets can’t always be amortized. Suppose that a public company acquires several subsidiaries for more than the market value of the subsidiaries’ assets. The additional value appears on the parent company’s balance sheet as an intangible asset called goodwill, which represents the value of anticipated future cash flows from the subsidiaries. The FASB says that publicly traded companies should not amortize goodwill, though private companies and not-for-profits may choose to do so.
The value of goodwill may be written down at some point if, for some reason, the acquired company is determined to be less valuable than originally expected—this is called impairment. But generally speaking, the company now has a larger asset base, meaning that the relationship between EBIT and EBITDA doesn’t change significantly.
Which Do You Need and Why?
If a company has high interest costs, it may prefer to highlight the company’s operating profitability rather than its net income, and therefore it will choose EBIT as a key performance indicator.
However, if the reason for the high interest costs is that the company has financed large-scale capital investment with debt, then it may prefer to use EBITDA, since depreciation and amortization charges are likely to depress EBIT.
Many managers may prefer to highlight EBITDA rather than EBIT if there’s a big difference between them, which might be the case if the company has paid for assets in cash. However, some investors are wary of EBITDA. Warren Buffet, for example, has said it’s too often used to “dress up” financial statements.
Using Accounting Software to Measure EBIT and EBITDA
EBIT and EBITDA are both widely used to measure and compare the profitability of businesses. They can be useful for demonstrating a company’s ability to generate profit from its core operations after stripping away the effect of interest payments on debt, taxes and—in the case of EBITDA—capital expenditure. However, neither EBIT nor EBITDA are GAAP-approved metrics, so companies that must comply with GAAP should use them in conjunction with approved metrics. Some investors are extremely wary of EBITDA because they think it can give an inaccurate view of a company’s financial health.
Cloud accounting software can help you track and report these and other financial metrics. With real-time access to all of your financial data, you can stay on top of what’s happening in your business whether you're in the office or working remotely. That way, you always have the most comprehensive and accurate view possible so you can make the best strategic decisions for your business.