EBIT vs EBITDA: No matter who you are, provided that you work in business, finance, and economics, by all means, the two terms EBIT and EBITDA are familiar to you.
They are key components to arrive at the value of Free Cash Flow, which is used to calculate a firm’s valuation. The two acronyms are defined in many finance materials, take Investopedia as an instance.
Both acronyms are the most popular metrics used to evaluate a company’s performance. They are different forms of net incomes. Investors and analysts prefer using EBIT and EBITDA to real NET INCOME since they exclude unnecessary items influencing the firm’s profitability such as taxes and depreciation.
As a student who is preparing for a finance career like Investment Banking, the two metrics are what you MUST know really well.
1. Definition of EBIT
|Definition: EBIT stands for Earnings Before Interests and Taxes. It is a firm’s income before Interests and Taxes are taken into account. When financial statement users look at EBIT, they ignore the firm’s taxes and interests and focus on the firm’s performance. EBIT is also called Operating Income.|
The most popular formula for EBIT is:
EBIT = NET INCOME + INTERESTS + TAXES
There are two ways to calculate EBIT, you can start with Revenues or Net Income, both of which are presented in the Income Statement.
Start with Net Income
You have net income from the Income Statement, then add tax payments and interest payments back. The total of Net Income, Taxes and Interests is EBIT.
Specifically, the EBIT is:
EBIT of 2020 = 108,500 (Net Income) + 46,500 (Taxes) + 5,000 (Interests) = 160,000
Start with Revenue
Take a look at the picture above, you can go down from revenue. You can take the figure of revenue, then less the cost of goods sold and operating expenses to arrive at EBIT.
EBIT of 2020 = 500,000 (Revenue) – 270,000 (COGS) – (30,000+15,000+25,000) (Operating Expenses)=160,000
The first approach is much more preferred since the items including taxes and interests are presented separately and clearly in the income statement.
2. Definition of EBITDA:
|Definition: EBITDA stands for Earnings Before Interests, Taxes, Depreciations and Amortizations. It gives financial statement users another kind of a firm’s net income (though most of the time, it acts as a proxy for cash flow of a firm). This type of net income doesn’t take interest and tax payments, and depreciations and amortizations into account. It’s basically the income of a firm after subtracting Costs of Goods Sold and Operating Expenses. For this reason, the value of EBITDA is always greater than that of EBIT.|
The easiest formula to calculate EBITDA is:
EBITDA = NET INCOME + INTEREST + TAXES + DEPRECIATIONS & AMORTIZATIONS
Similar to EBIT, from the Income Statement, we have two ways to arrive at the value of EBITDA. You can determine its value by starting from either the top line of revenue or the bottom line of the Income Statement.
Start with Net Income
You take the net income from the Income Statement, then add back tax and interest payment, and depreciations and amortizations. As mentioned in the formula above, the sum of Net income, tax and interest payments, and depreciations and amortization is EBITDA.
EBITDA of 2020 = 108,500 (Net Income) + 46,500 (Taxes) + 5,000 (Interests) + 25,000 (Depreciations & Amortizations) = 185,000
Start with Revenue
You take the value of revenue from the income statement, then remove all the cost of goods sold and operating costs. The residue is EBITDA.
EBITDA of 2020 = 500,000 (Revenue) – 270,000 (COGS) – (30,000+15,000) (Operating Expenses) = 185,000
3. What does EBIT Represent?
Instead of looking at the bottom line, which is burdened by capital structures and tax obligations, an analyst prefers using EBIT when comparing with other companies to gauge whether a company has more potential than another.
EBIT can be seen as the Operating Profit of a firm. That’s why it shows the firm’s profitability from the core operation.
Since the capital structures are different from companies, which affect the bottom line of a company, EBIT is more favourable in eliminating these significant differences. When stripping these burdens out of the formula, the analyst can have a direct look at whether the core business of a firm is able to generate profits.
In many circumstances, the bottom line in the income statement presents a loss, however, the core operation of a firm can make a positive income. This can be seen as a potential for the firm in the long-term. Gradually, when the operation becomes more stable, cash flow generated from the core business can make up for debts and tax obligations of the firm.
4. What does EBITDA Represent?
EBITDA is a good representation of “cash flow” of a firm. As can be seen in the formula, depreciations & amortizations are removed, since it is a non-charged item in a financial year. Though in fact, the value of tangible and intangible assets was charged when bought.
If an analyst solely cares about a “basic” cash flow”, EBITDA is a good option. It gives analysts a better picture of how a core business of a firm can form a cash flow. The value of assets, the capital structures and tax obligations are different between companies, so when putting different companies on the table to compare and assess, analysts calculate EBITDA to gauge the potential of the firms.
EBITDA is quite a popular value among companies which have a sizable amount of assets. In this case, it is an important indicator of company performance. Though it is not the value of practical cash flow at a time, it acts as a proxy for cash flow and lets analysts assess how much debt a company can handle by its operation.
5. EBIT vs EBITDA: Limitations of EBIT and EBITDA
Though both metrics have favourable features for analysts, financial statement preparers can manipulate these metrics easily. When looking at the potential of a firm, EBIT and EBITDA are not enough standard measures. These metrics barely give investors and analysts a full picture of a firm’s operation.
To enhance the firm’s financial health by boosting the value of EBIT and EBITDA, the firm can furlough or lay off employees to decrease the operating expenses. Another way to manipulate EBIT is that the firm tries to squeeze the cost of goods sold, leading to the low quality of their products.
Fact: A lot of renowned investors do not appreciate EBIT and EBITDA such as Warren Buffet. He always opposes the use of the two metrics to analyze financial statements.
Businesses should be very careful in relying too much on EBIT and EBITDA. These are a few reasons:
- EBIT and EBITDA couldn’t substitute for cash flow. It doesn’t present for the real cash flow a company generates, as both tax and interests are required to to be paid periodically. Without paying debt and tax, a business couldn’t operate for long.
- For companies with being highly leveraged and a substantive amount of assets, EBIT and EBITDA only present the core business performance without providing a clear picture of earnings.
6. EBIT vs EBITDA: Why is EBITDA preferred to EBIT?
It’s actually hard to tell which one is more favored. The simple reason can be the larger value of EBITDA compared to that of EBIT, which makes the money generated from the core operation look great and substantive.
Each metric has its own role in assessing the performance of a business, that explains why analysts should use both in tandem.
After spending time working on these both acronyms, here’s a quick summary of EBIT and EBITDA:
|Formula||EBITDA = NET INCOME + INTEREST + TAXES + DEPRECIATIONS & AMORTIZATION||EBIT = NET INCOME + INTEREST + TAXES|
|What does it present?||It acts as a proxy for cash flow from the core business operation of a firm, before taking debt and tax payments, and depreciation & amortization of assets||It acts as a proxy for a firm’s profitability, since another name is operating income. It is the profitability after removing burdens from tax and interest payments|
|Depreciation & Amortization||Deduct||Non Deduct|
|Whom is this money available to?||Equity and debt holders, and the government||Equity and debt holders, and the government|
|What is it used for?||For example, it’s applicable to compare different kinds of companies, in which a company has a substantive amount of assets while the other doesn’t have that much. EBITDA solely focuses on the ability to make money from its core business operation||Since it’s called the operating income, it measures the ability to generate profit from the core business operation of a firm|
|Level of analysis||It couldn’t provide a clear picture of a firm’s earnings||It couldn’t provide a clear picture of a firm’s earnings|
7. Conclusion of EBIT vs EBITDA
Both EBIT and EBITDA are key metrics to evaluate the performance of a business. Nonetheless, keep in mind that neither indicators could provide the big picture of the firm’s earnings. It’s important to deploy various multiples and metrics to have a better overview of how the firm is operating.
Also, EBIT and EBITDA are key metrics to arrive at more difficult terms in financial modelling and valuation such as FCFF and FCF, which will be asked a lot in an interview. Thus, you should grasp what is needed such as EBIT and EBITDA, helping you study far more quickly afterwards.
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