Updated July 14, 2023
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 unaffected by the cost of capital interest and tax expenses.
Explanation
EBIT refers to the operating income the company earns by conducting its operations. It means the company’s net Income (Revenue-Expense) to calculate which tax and interest expenses are not deducted.
The Formula for Earnings Before Interest and Tax (EBIT)
Earnings before Interest and Taxes(EBIT) is calculated as follows:
|
Particulars |
Amount |
| Revenue or sales | xxx |
| Direct Expenses: | |
| (-)Cost of material | xxx |
| (-)Cost of Labor | xxx |
| (-)other direct expenses | xxx |
| Gross Profit | xxx |
| (-)indirect expenses | xxx |
| (excluding interest and taxes) | |
| Net profit before interest and Taxes | xxx |
It can also be calculated in another manner where:
Example of Earnings Before Interest and Tax (EBIT)
For Example, The income statement of XYZ Inc is as follows:
| Particulars | Amount (in $) |
| Revenue from a sales operation | 70,000 |
| cost of raw material | 25,000 |
| cost of labor directed toward manufacturing | 18,500 |
| other direct expenses | 6,500 |
| Indirect Expenses | 16,000 |
| Interest expenses | 425 |
| Income from interest | 112 |
| Net non-operating income | 415 |
| Total Earnings before deduction of taxes | 4,102 |
| Income taxes | 3,500 |
| Net earnings | 602 |
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 and tax expenses. Other incomes are also included in the calculation of EBIT. So, the calculation of EBIT is as follows:
| Particulars | Amount (in $) |
| Revenue from a sales operation | 70,000 |
| (-)Direct Expenses | 50,000 |
| Gross Profit | 20,000 |
| (-)Indirect Expenses | 16,000 |
| Net operating Profit | 4,000 |
| (+)Net operating income | 415 |
| (+)Interest Income | 112 |
| EBIT | 4,527 |
EBIT is calculated as
- EBIT = 602 + 3,500 + 425
- EBIT = $4,527
This shows that after bearing all the operating costs 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 to analyze the company’s profitability. It includes deducting operating expenses like Rent of office, Salary of employees, electricity bills, printing, stationary, etc. So, before calculating the Net Profit of the company, a calculation of EBIT should be done. While calculating the company’s Net profit, 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 company’s shareholders commonly use this figure as a dividend from this profit. The relationship between EBIT and Net Profit is shown below:
| Particulars | Amount |
| Revenue or sales | xxx |
| Direct Expenses: | |
| (-)Cost of material | xxx |
| (-)Cost of Labor | xxx |
| (-)other direct expenses | xxx |
| Gross Profit | xxx |
| (-)indirect expenses | xxx |
| (excluding interest and taxes) | |
| EBIT | xxx |
| (-)Interest | xxx |
| (-)Income taxes | xxx |
| Net Profit | xxx |
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 operations 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 the EBIT computation. If interest is received on investment or in the form of late fees from customers, it may not be included in the EBIT computation. EBIT is also calculated in reverse order by taking Net profit after interest and taxes and adding interest and tax expenses.
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 Earnings before interest and taxes.
- The shareholders use the net profit for calculating their Earnings per share.
Advantages of EBIT
Advantages are provided and discussed below-
- With the help of Earnings before Interest and Taxes (EBIT), investors can compare different companies in the same industry. For example, suppose an investor wants to purchase a share. In that case, the EBIT of different companies with different rates 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 to produce goods and services. To Finance, these investment companies have to raise debt. Companies in 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 company’s earning potential, 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 expenses, which may vary from company to company.
Disadvantages of EBIT
Disadvantages are provided and discussed 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 with a huge investment in fixed assets with another company with few fixed assets, the EBIT of the former company turns out to be lower as depreciation expense reduces the profit of the former company.
- Some companies raise a huge amount of debt due to low performance or low cash flows, resulting in high-interest expenses. As EBIT is not considering the deduction of interest expenses, this will enhance the company’s earnings and 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 in the same industry than Net profit, as taxes rate and interest expenses may vary from company to company.
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