Every business under the sun exists to make a profit and gradually expand their profit margin, but the only way to really know whether that’s happening is through good accounting practices. One of the many ways to evaluate the financial health of a company is to look at net income, the true “bottom line” of a firm that indicates income after accounting for all costs, expenditures, depreciation, amortization, interest, and taxes. While net income is an important measure, many companies also look to EBIT for a more accurate snapshot of their finances.
What is EBIT?
Short for earnings before interest and taxes, EBIT is an accounting concept that is used to measure a company’s profitability. Unlike net income, however, EBIT measures profitability of business operations exclusive of debt and tax considerations. For this reason it is also sometimes known as operating profit. Because EBIT is not considered part of the official U.S. Generally Accepted Accounting Principles (GAAP), publicly traded companies are not required to include it in financial reporting statements.
Even though calculating earnings before interest and taxes is not a requirement, many firms choose to use it as an analytical tool because of the fact that it gives an accurate picture of the company’s ability to generate revenue from core business operations. This is a useful metric for, among other applications, comparing two similar companies. Since a company’s capital structure and tax burden can be wildly different from firm to firm, EBIT allows the company’s core earnings generation to be compared more accurately.
As noted, EBIT is sometimes used interchangeably with the terms operating profit, operating earnings, or operating income. The terms can be used in this way, but they are usually reserved for companies that don’t have any non-operating income; non-operating income refers to income that comes from activities unrelated to the core business like investments in securities or the sale of assets. For companies that do have non-operating income, the term EBIT is more accurate.
How is Earnings Before Interest and Taxes Calculated?
The three main elements of the EBIT calculation are a company’s earnings, interest, and taxes. Earnings are defined as income generated after subtracting operating expenses. Interest refers to the regular interest payments needed to service any debt on the balance sheet, and taxes are of course dependent on various factors, such as a firm’s location. There are several different EBIT formulas that can be used depending on what information you start with:
EBIT = net income + interest + taxes
EBIT = revenue – cost of goods sold (COGS) – operating expenses
EBIT = gross profit – operating expenses
With the information contained in a company’s financial statements, EBIT is relatively easy to calculate. But the same pieces of data can also allow you to calculate EBITDA, which is earnings before interest, taxes, depreciation and amortization; this alternative accounting concept is useful for determining income from business operations before taking into consideration the costs of maintaining assets. This is a further level of fine-tuning the analysis of a firm’s profitability.
Advantages of EBIT
As noted above, EBIT can be used to compare the core profitability of two different companies. For instance, companies in different states may have different tax liabilities and yet be comparable in other significant ways. The other major advantage is related to debt; many companies take on substantial debts in order to invest in new assets that can help the business grow. Because of the differences in amount of debt and interest payments, it can be hard to compare companies that are otherwise similar. A look at earnings before interest and taxes allows the central business models to be evaluated on the same level.
Disadvantages of EBIT
A crucial aspect of any company’s financial health is cash flow, the actual receipt of liquid funds. Omitting interest expenses can be useful in some analyses, but it can also falsely inflate the cash flow picture. In some cases, for example, a high EBIT value may actually be hiding substantial interest payments that keep cash flows much lower. Additionally, a company with a lot of fixed assets (like buildings or machinery) may have lower EBIT because depreciation expenses and amortization expenses reduce overall profit; in such cases the EBITDA calculation would be more useful.
The Importance of Having Good Data
Using EBIT or any other analytical tool to evaluate a firm’s profitability can only really work and be useful if you have access to accurate data. While there are many sources for good financial data, many small providers are limited in the services they can offer and the consistency of their own data sources. Unreliable data or frequently switched sources can end up causing significant problems for your fintech projects.
Relying on Intrinio, by contrast, gives you access to a diverse team of financial data experts who can help provide reliable data from reputable, established sources. We offer total transparency into our sources so you can feel confident about integrating the data into your platforms. If you’re ready to switch to a new, trustworthy, and innovative source for data, contact us today to request a consultation or take a look at our financial data packages.
Image and article originally from intrinio.com. Read the original article here.