Learn about EBIT, how accountants calculate it, and why businesses often prefer to use it to share their performance with creditors and investors.
Definition and Examples of EBIT
EBIT is an acronym for earnings before interest and taxes. Accountants use EBIT to identify a business’s net income before deducting expenses such as income tax and interest. EBIT is a non-GAAP measure—meaning it is not a traditional accounting principle. It is used to share a company’s operational earnings and ability to generate a profit. EBIT can be used in two ways. First, it is used within a company by decision-makers who want to evaluate its operational performance and profit. EBIT is also used by investors who want to understand a company’s profit.
Alternate names: Operating earnings, profit before interest and taxes Acronym: EBIT
There are two formulas for calculating EBIT. The first is considered a direct definition of EBIT because revenue is adjusted with all related expenses. It looks as follows: Earnings - Cost of Goods Sold - Operating Expenses ＝ EBIT The second formula is considered indirect because it shows us what needs to be added to the net income. It’s calculated this way: EBIT = Net Income + Income Tax + Interest Expense Although both equations will end with the same net income, the formulas are used for different reasons. The first is used to measure operational performance, while the second is analyzing profitability. Let’s explore an example of both EBIT formulas in action. Beautopia is a company that manufactures wigs, which are later sold in retail spaces. This year, its income statement shows the following:
Earnings: $1,000,000Cost of Goods Sold: $600,000Gross Profit: $400,000Operating Expenses: $100,000Interest Expense: $50,000Income Tax: $50,000Net Income: $200,000
Using both formulas, Beautopia’s EBIT comes to $300,000.
How EBIT Works
EBIT is categorized as non-GAAP earnings, meaning it is not recognized as a generally accepted accounting principle. Non-GAAP is considered an alternative to traditional accounting methods as it measures a company’s earnings. A company’s EBIT is performed at the end of the fiscal year using data included in its income statements. The purpose of EBIT is twofold. Businesses often use EBIT internally to make decisions related to the operation and management of their company. By evaluating earnings, cost of goods sold, and expenses, a company can identify how to save and make more money within their business. Investors also use a company’s EBIT to understand that company’s profit. By analyzing operating earnings instead of net income, investors can realize profitability without considering the interest expense or income tax. Investors analyze the EBIT metrics of various companies within an industry when they want to understand operational profit and performance. The EBIT metrics can help them decide whether or not to invest in a company. For instance, say an investor is interested in two companies that manufacture wigs. They will need to look at the gross profit, net income, and operating expenses of each to understand the businesses’ true profitability. Finally, EBIT is included in various financial ratios developed by companies. These calculations have an interest coverage ratio as well as an operating profit margin.
