Earning Before Interest and Taxes (EBIT)
Earnings before interest and taxes (EBIT) is called operating income which is used to measure the profit of the company.
Profit of the company can be calculated by subtracting the cost of goods sold and total expenses from the total revenue of the company.
Profit of the company gains without regard interest and taxes calculated by EBIT. Due to this reason for the calculation of operating earnings or profit EBIT calculation is used. EBIT margin is the ratio of earning before the taxes and interests to revenue earned.
Definition: What is EBIT? (EBIT Margin)
Investor and creditor used EBIT calculation to find how successful a company is for its core operation without worrying about the tax ramification or capital structure’s cost.
From these analysts analyze that in the real world ideas and business activities behind them work or not.
By examining the operation of the company through EBIT analysts can know the ability of them to pay the debt obligation and health of the company.
Earnings before interest and taxes (EBIT) formula can be calculated by subtracting the cost of goods sold and operating expenses from the total revenue of the company.
EBIT = Total revenue – COGS – Operating expenses
This is also called the direct formula because for total expanse it adjusts the revenue. For the derivation of EBIT equation indirect method can be used which start with the net income and back out the taxes and other expenses. Form an indirect method it can be calculated as
EBIT = Net income + Interest + Taxes
From the first formula, we know directly that what is taken out of earning, Second equation tells that what is the need to add back in the total income.
From these two equations, we can understand this ratio by two way. The result of both equations will be the same.
Motley investors do not add the interest income in the calculation. e.g if interest is the primary source of income then investors need to add that however, it is not an operating activity.
This calculation not added to the income statement mostly. Because this calculation not mandated by the GAAP.
A financial statement which includes this calculation that subtotal and calculates the EBIT before the non-operating expenses are listed.
Due to this analyst check the earning from the operation and then compare them with interest expenses and taxes.
Now take the example of earning before interest & taxes.
Now we take the example of an equipment supplier company. Income statement of this company’s activities listed below.
- Sales = 1,000,000 dollars
- CGS = 650,000 dollars
- Gross profit = 350,000 dollars
- Operaring expanses = 200,000 dollars
- Interest expenses = 50,000 dollars
- Income tax 10,000 = dollars
- Net income = 90,000 dollars
Net income for year of the above mention company is $90,000. For the calaculation of EBIT ratio we need to add interst and operating expanses back in.
EBIT = 90,000 + 50,000 + 10,000
= 150,000 dollars
Sor Ebit for the year for the company is 150,000 dollars. So after the paying of all the expenses and cost of goods the company gets a profit left over of $150,000.
This leftover profit is used to pay the interest, taxes, or pay down debt.
When we discuss EBIT Margin then it is the ratio of Earnings before Interest and Taxes to net revenue – earned and we already explain it before.
Analysis and Interpretation
Without taking into consideration the financial structure of any company this ratio is used to tell many operations of the company and the company’s financial position.
Instead of net income in this calculation by the operating earnings of the company we evaluate how profitable the operations of the company without taking into consideration the cost of debt.
Through the EBIT calculation analyst compare the operating activity efficiency of different companies without regard to their debt obligations.
Now we consider two company, company A and company B. Company A have a net profit of 1,000,000 dollars and company B have et profit 800,000 dollars.
Now here if we ignore the EBIT calculation then company A look the better company as compare to company B.
We assume that the expenses of company A are 50,000 dollars and interest expenses of company B are 400,000 dollars.
Now if we added back these interest expenses then the operations of company B is more profitable as compared to company A.
Company B is more leverage due to which he needs to pay much interest as compare to company A.
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