In order to make a meaningful judgement about a company, you depend on key figures that enable you to carry out a (also international) comparison. An economic indicator capable of this is EBIT. But before you work with this indicator, you should understand exactly what it reveals, and how to calculate it.
The acronym EBIT stands for "earnings before interest and taxes" and describes the profit of a company without expenses and income from interest and taxes.
The EBIT formula is often used in annual reports in English-speaking countries, and in the USA it is used alongside US GAAP (United States Generally Accepted Accounting Principles). This key figure is used to evaluate the result of operating activities, without including revenues and expenses from taxes and interest. In other words, net income for the year is adjusted for taxes and interest. This value therefore does not correspond to the actual net result achieved at the end and which increases or decreases the company's assets, but only to an – albeit not unimportant – preliminary result.
However, the exact interpretation of the term EBIT is neither internationally uniform nor clearly defined. In the USA, for example, the value means exactly what the acronym says to a large extent, namely earnings before interest and taxes, but interest income is often added to this. However, the items that are included differ from case to case, so this requires further explanation.
Since the EBIT ratio is not standardized, there is no consistent method for calculating it. Different enterprises not only often use different definitions of value, but also do not always include the same items, meaning that the results are only comparable to a limited extent.
As long as you are aware of these limitations, however, you can use EBIT to compare companies – not least across national borders. Since taxes vary from country to country, the ratio is a useful indicator for comparing business performance. Especially since interest income and expenses usually have nothing to do with the actual business activities of an industrial company, for example, and therefore contribute little to the evaluation of the operating result.
In addition to EBIT, there are two other similar key figures: the EBITA (earnings before interest, taxes and amortization) and the EBITDA (earnings before interest, taxes, depreciation and amortization).
The EBIT calculation differs from what you’ll be used to from the income statement. However, it can form the basis for the calculation, since the key figure also appears in the income statement as an intermediate step. Therefore, EBIT can be calculated either according to the total cost method or according to the cost-of-sales method. Both methods deliver EBIT based on sales revenue.
According to the total cost method:
| Sales revenue | |
|---|---|
| +/- | Inventory changes |
| + | Capitalized assets |
| + | other operating income |
| - | other operating expenses |
| - | Material costs |
| - | Personnel costs |
| = | EBITDA |
| - | Depreciation of property, plant, and equipment |
| = | EBIT |
According to the cost-of-sales method:
| Sales revenue | |
|---|---|
| - | Manufacturing costs |
| = | Gross profit |
| - | Distribution costs |
| - | General administrative costs |
| + | other operating income |
| - | other operating expenses |
| = | EBIT |
The ratio between sales and EBIT is called the EBIT margin. This value indicates the percentage share of EBIT in sales.
Another method of calculating EBIT is based on net profit (or net loss). From this amount, you can calculate back because it already contains taxes and interest. This variant is – as you can quickly see – much simpler. In addition, you have to calculate the annual net profit for your balance sheet.
| Annual net profit | |
|---|---|
| +/- | Income taxes |
| +/- | Extraordinary income |
| +/- | Interest costs |
| = | EBIT |
With this procedure, you must therefore deduct the interest and taxes that you already paid or received.
In our example, there are two different companies from different countries and with different financial situations. For the sake of simplicity, they both calculate their EBIT using the same procedure and can therefore be compared. While company A made a net profit of one million dollars for the year, company B made 1.1 million dollars. Company A lives in a state with a high tax rate and therefore has to pay $200,000 in income tax. To finance this, the company took out a loan of $500,000 and has to pay 5% interest on it, i.e. $25,000 per year.
The state in which company B is located charges only $120,000 in income taxes. In addition, this company is financed by a loan of $200,000 at the same interest rate and holds $100,000 in another company that earns it $5,000 in interest. This results in interest costs of $5,000.
Company A
| $1,000,000 | Annual net profit | |
|---|---|---|
| + | $200,000 | Income taxes |
| +/- | $0 | Extraordinary income |
| + | $25,000 | Interest cost |
| = | $1,225,000 | EBIT |
Company B
| $1,100,000 | Annual net profit | |
|---|---|---|
| + | $120,000 | Income taxes |
| +/- | $0 | Extraordinary income |
| + | $5,000 | Interest cost |
| = | $1,225,000 | EBIT |
Although Company B was therefore able to record a higher net profit for the year, the EBIT for the two companies is exactly the same. Only the different taxes and different financing arrangements result in different annual net profits. In terms of EBIT, both companies were equally successful.
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