Earnings before interest and taxes (EBIT) and other ´Earnings Before...´
Encyclopedia of Business Terms and Methods, ISBN 978-1- 929500-10-9. Copyright © 2012 by Marty J.Schmidt. Revised 28 March 2012.
The Meaning of EBIT (Earnings Before interest and Taxes),
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization),
and other Selective Income Metrics ("Earnings Before..." Metrics)
The family of "Earnings before..." income metrics addresses questions like these:
- Did the company earn acceptable profits last period?
- Did the company reach it's objectives for earnings growth?
- How do the company's earnings compare to earnings of its competitors?
Such questions are addressed by comparing earnings figures from the company's income statement to similar figures from previous period statements, or to competitor's figures, or to industry standards. The first financial metric that comes to mind at the mention of earnings is the income statement "bottom line," reported overall net income (or net profit, net earnings, or residual profit). However, in many cases, overall net income gives a misleading or less-than-helpful answer to such questions.
The problems with using net income (net profit, net earnings) as a stand alone measure of earnings performance have to do with several factors that can enter the net income calculation. Remember that net income from the statement is simply a detailed application of the income statement equation:
Income = Revenues – Expenses
However, calculations that lead to the income statement bottom line often include expense items for arbitrary accounting conventions, government-imposed taxes, unusual or extraordinary gains and losses, and other revenues and expenses from outside the company's normal business operations. When present, these expenses "muddy the waters," making reported net income a less-than-direct measure of the company's earnings performance in its core business.
For example, when discussing earnings performance in annual reports, Domino's Pizza LLC focuses on EBITDA (Earnings before interest, taxes, depreciation and amortization). Domino's operates in an intensely competitive industry and, as of 2012, has been adjusting its strategic objectives for several years. In this case, it is crucial for senior management and investment analysts to measure earnings performance precisely: year-to-year changes of just a few percentage points can be important indicators of success with strategic changes or of prospects for future growth. However, the company has substantial investments in assets which create large and varying degrees of depreciation expense from year to year, and the company operates worldwide in a variety of different tax jurisdictions. For evaluating Domino's earnings performance, year-to-year changes in EBITDA are a more precise, more informative metric than net income.
Income performance metrics such as Operating Income, EBIT, and EBITDA are sometimes called focused measures of income or selective income metrics. Sections below describe the derivation and use of the most commonly used of these.
All of the good reasons for considering selective metrics notwithstanding, remember that after every reporting period, contributions to shareholder dividends and/or to retained earnings (contributions to balance sheet equity) are determined by bottom line net income, not the selective income metrics
The most frequently used selective income metrics are derived completely from income statement contents.
• "Earnings Before..." Metrics Compared
• Operating Income (Operating Profit)
• Earnings Before Taxes (EBT, Pre-Tax Earnings, Profit Before Tax, PBT)
• Earnings Before Interest and Taxes (EBIT)
• Earnings Before Interest, Taxes, Depreciation and amortization (EBITDA, or Operational Cash Flow)
• Earnings Before Extraordinary Items, Interest, Taxes, Depreciation, and Amortization
• Income Statement Example
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"Earnings Before..." Metrics Compared
The table below summarizes and compares income metrics on the basis of their contents. For those familiar with income statement structure and content, the names of individual income metrics seem self-explanatory.
Nevertheless, when producing or using these metrics, or comparing earnings metrics from different companies, remember that most of the metrics discussed here allow the company reporting earnings a limited degree of judgement or preference regarding exactly what goes into the metric calculation. The "GAAP-defined" metrics below offer the least flexibility of this kind. Those listed as "Non-standardized" offer more flexibility In any case, when presenting "Earnings before..." metrics, it is good practice to include a note stating precisely what the reported metrics include and what they do not include..
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Operating Income (Operating Profit)
Operating income (operating profit, earnings from operations) represents the company's earnings from its core business. Operating income figures show the company's earnings before adding revenues and expenses for extraordinary items, and (if the company is not in a financial industry) before financial earnings or expenses.
Operating income is a standardized, GAAP-defined metric.
Operating income is shown first on the income statement in currency units, but however operating income is often presented and discussed as operating margin (operating income expressed as a percentage of net sales revenues). Expressed either way—as a margin percentage or in currency figures—operating income is an appropriate metric for comparing earnings to competitors in the same industry or with industry standards.
It is possible for a company to report both a positive operating income and a negative overall negative net income at the same time.This occurs, for instance, in periods with large unusual or extraordinary cost items, such as costs of workforce reductions, or large fines or legal judgements. This can also occur when the company declares investment losses or unusually large financial expenses (for companies not in a financial industry). When operating income and net income differ in this way, expect the corporate officers to emphasize operating income results in the annual report, so as to show that the company is performing well in its core business and that prospects for future earnings are good.
Of course companies can also report the reverse situation—a positive net income accompanied by a negative operating income. Here, profitability is "saved" or rescued by extraordinary or financial income, perhaps from the sale of real estate or other assets, or the sale of investment securities. Even though net profit is positive, however, the situation signals the need for serious concern from the company's shareholders and senior management because he core business is not performing well.
Operating income before taxes is normally shown directly on published income statements. Very simply, operating income is derived as:
Operating Income = Net sales revenues
– Cost of goods sold (or Cost of sales, or cost of services)
– Operating expenses
In the example below, Grande Corporation reports:
Operating income before taxes: $3,130,000.
Operating income after taxes on operating income: $2,172,000
Net income after taxes: $2,126,000
The example statement in this section shows only lines and figures relevant to the discussion on operating income. For a more complete version of the same income statement, see the example statement at page bottom.
Grande Corporation Net sales revenues........................... 32,983 Operating income before taxes................. 3,130 Net financial gain (expense).................. (393) Net Income (Profit)............................2,126 Note: Normally, operating income after taxes is not reported as line item on the income statement. The figure can be calculated as: Operating income before taxes................. 3,130 |
Operating income is usually reported and discussed on a pre-tax basis. There is a potential confusion present when calculating and reporting Operating income after taxes. Note from the above calculations that the income tax added back is "Tax on operational income only," and not the normal income statement line "Income tax on operations." That is because the latter may include—as it does here—the impacts of financial revenues and financial expenses as well as ordinary "Operating income." Operating income and financial income are taxed at the same rate in most localities, and tax on both kinds of income are often represented (as above) with a single tax line. Here, in order to find and add back the appropriate tax on "operational income only," the analyst multiplies the marginal tax rate on operating income (here, 35%) by the before tax operating income figure. Here, that is
Tax on operating income only = 35.0% * $3,130
= $1,096
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Earnings Before Taxes (EBT or Pre-Tax Earnings)
Earnings before taxes (EBT, or Pre-tax income, or Profit Before Taxes, PBT) shows company earnings for a period without considering tax expenses. Pre-tax income is useful for compare earnings between companies in different tax jurisdictions.
A similar comparison occurs, for instance, when considering the salaries of individual employees: two employees may have identical gross salaries and at the same time different after-tax income (different "take home pay") because they have different income tax situations. Pre-tax salary figures show, however, that the employer pays both employees the same salary. Similarly, the pre-tax earnings metric is a more direct comparison of earnings performance between companies in different tax jurisdictions.
Using the income statement equation, Pre-tax earnings for a company are in principle simply:
Pre-Tax Income = Revenues – Expenses (except tax expenses)
In reality, the simplest way to calculate and communicate pre-tax income given income statement data is to start with the reported (after tax) net income and then add back all taxes that were subtracted earlier. For example, using again the Grande Corporation example income statement data:
Net (after tax) Income ......................2,126 Plus income tax paid on operations.......... 958 Pre-tax Income (Earnings before taxes).......3,202 |
All figures in the EBT example above are GAAP-defined. For that reason, EBT (PBT, Pre-tax earnings) is listed here as "GAP-defined."
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Earnings Before Interest and Taxes (EBIT)
EBIT (or, Earnings before interest and Taxes) is another pre-tax income metric, slightly more selective than EBT (above). As its name says, EBIT represents earnings before tax expenses and before interest expenses are considered.
EBIT and EBITDA (next section) are popular metrics among investment analysts, who compare earnings figures from companies with different capital structures. Companies that are highly leveraged (obtain relatively more of their funding from borrowed funds rather than owner's equity) pay relatively more interest expenses than companies that are not highly leveraged. By measuring income before interest expenses are factored in, EBIT allows a more direct comparison of earning performances between companies with different levels of leverage (different capital structures).
As with EBT (Earnings before taxes, above), EBIT is also useful for comparing earnings of companies from different tax jurisdictions.
The important characteristics of EBIT include these;
- EBIT is the same as pre-tax net income, except that EBIT also excludes the contributions of interest expenses paid.
- EBIT is usually presented as pre-tax income from operations as well as all non operational income and expense (except for interest paid). When presented this way, EBIT reflects contributions of extraordinary gains and extraordinay costs as well as depreciation and amortization expenses. Note however, that EBIT is a not defined by GAAP and some companies report EBIT omitting extraordinary items and other non operational income and expenses from the calculation.
- For companies not in a financial industry, EBIT excludes the impact of interest paid.
- EBIT is a non-standardized metric (not GAAP-defined), and reports of EBIT may or may not include financial income and non-interest expenses, depending on the judgement of the reporting company.
In principle, using the income statement equation, EBIT represents:
EBIT = Revenues
– Expenses (except tax expenses and interest expenses)
When reporting non-standardized metrics like EBIT, it is good practice to include a statement indicating the contents of "Revenues," that is, whether or not financial revenues and other non operating revenues are included.
In practice, EBIT is more easily computed and calculated from typical income statement line items by starting with Net Income and adding back interest expense and tax expense. Using line items and figures from the example income statement at page bottom, Grande Corporation's EBIT for the year can be calculated as:
Net (after tax) Income ......................2,126 Plus interest expense paid.................... 511 |
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Earnings Before Interest, Taxes, Depreciation and amortization (EBITDA or Operational Cash Flow)
EBITDA (or, Earnings before interest, taxes, and depreciation and amortization, or Operational cash flow) is yet another pre-tax income metric, still more selective than EBIT (previous section). As the name suggests, EBITDA represents earnings before tax expenses, interest expenses, depreciation expenses, and amortization expenses.
Like EBIT, the exclusion of interest and tax expenses from EBITDA makes the metric useful for comparing earnings performances of companies that:
- Have different capital structures (and thus different levels of interest obligations).
- Operate in different tax jurisdictions and thus have different tax rates.
In addition, the EBITDA metric recognizes that depreciation and amortization expenses can be large, and they can very considerably between companies or even from year to year within one company. Depreciation and amortization expenses, moreover, do not signal real cash flow; they are simply accounting conventions prescribed by tax authorities. As such, they further distort the picture of earnings performance represented by overall net income. By excluding depreciation and amortization expenses, EBITDA is immune to such distortions.
Some of the primary characteristics of EBITDA include the following:
- Because it excludes depreciation and amortization (non cash flow expenses), EBITDA is sometimes called Operational cash flow.
- EBITDA (like EBIT, above) is not defined by GAAP and is a non standardized earnings metric.
- Some accountants and financial specialists choose to include only operating revenues and expenses in the metric.
- Others believe the definition should include financial income and expenses (other than interest expenses), as well as non operating expenses including extraordinary gains and losses.
- Those in the former category, who include only operating revenues and expenses, claim that EBITDA is equivalent to Operating Income and they will even use the two terms (Operating income and EBITDA) interchangeably. The position presented here is that equating EBITDA and operating income is a risky at best: operating income as defined by GAAP can include depreciation expenses, whereas EBITDA by definition does not.
- Those who allow financial and non-operating revenues and expenses into EBITDA obviously do not claim.equivalence between operating income and EBITDA.
Using the income statement equation, EBITDA represents:
EBITDA = Revenues
– Expenses (except tax expenses, interest expenses,
depreciation expenses, and amortization expenses)
In practice, EBITDA is more easily and clearly derived from typical income statement line items by starting with Net Income and adding back interest, taxes, depreciation, and amortization expenses. Using line items and figures from the example income statement below, EBITDA for Grande Corporation for the year completed is calculated as:
Net (after tax) Income ......................2,126 Plus depreciation expense, store equipment.... 120 |
Note that for the example used in this entry, EBITDA ($4,372,000) exceeds Operating income ($3,130,000). This illustrates again why equating EBITDA and Operating income is risky, at best. Operating income is lower than EBITDA here for two reasons:
- Operating income reflects depreciation expense, while EBITDA does not.
- The anlayst for these examples here chose to include non operating revenues and expenses in EBITDA , whereas these items are normally excluded from operating income.
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Earnings Before Extraordinary Items, Interest, Taxes, Depreciation, and Amortization
Earnings Before Extraordinary Items, Interest, Taxes, Depreciation, and Amortization (EBEITDA) may be the most selective of all the selective income metrics described.in this entry. However, as with other non-standardized income metrics, no one can know with certainty what EBEITDA represents unless the metric is accompanied by a statement indicating specifically what is included and what is excluded.
Note the following regarding EBEITDA
- EBEITDA might be considered just an instance of the slightly less selective metric, EBITDA, where the person reporting has simply taken the trouble to clarify some of the potential ambiguity in EBITDA by declaring that extraordinary items are definitely not included in EBEITDA.
- EBEITDA becomes a useful and informative metric in situations where an EBITDA metric is also in view, and where EBITDA does include large extraordinary items. In such cases, EBEITDA may be viewed as a better measure than EBITDA of the company's earning performance in its core business.
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Income Statement Example
Example calculations above use line items and figures from the example income statement below. This example represents a company that manufacture and sell goods, but the structure and top level headings are typical across a wide range of industries. A company that sells services might list "Cost of services" instead of "Cost of goods sold" but notwithstanding such minor differences, the income statement structure and contents are nearly universal.
Grande Corporation Gross sales revenues.................33,329 Gross profit................................. 10,940 Operating expenses Operating income before taxes................ 3,130 Financial revenue & expenses Income before tax & extraordinary items..... 2,737 Extraordinary items Net Income (Profit)..........................2,126 |
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