Of the many acronyms small business owners have to keep in mind, EBIT and EBITDA rank high on the list. Though they measure similar things, there are some important distinctions between the two. Once you’re familiar with the basics of EBIT vs. EBITDA, you’ll be able to use them to gain a fuller picture of your company’s profitability.
To help you understand EBIT vs. EBITDA, we’ve put together this guide outlining each one, the main differences between them, and some examples of when to use them.
EBIT stands for Earnings Before Interest and Taxes, also sometimes referred to as operating income. Let’s take a look at what each part of the acronym means to help you better understand EBIT as a whole.
Earnings refers to net income or the bottom line. Knowing how much earnings your company has is a critical factor in calculating EBIT. You’ll need to have an exact earnings figure for your company for a proper EBIT calculation.
This classification includes any interest payments you make on credit or loans.
The tax part of EBIT comprises whatever dollar value your company must pay in federal and state taxes as stated by the law. Tax laws vary throughout the country, which makes comparing similar companies under different tax jurisdictions complicated.
What Does EBIT Show?
Businesses use the EBIT formula as a profitability measurement. By removing taxes and interest, a clear picture emerges of the profit a company makes solely based on its operations.
If you’re wondering does EBIT include depreciation, the answer is no—though we’ll get to depreciation in a minute when we look at EBITDA.
Why Use EBIT?
EBIT has become popular because it allows investors a different perspective on a company’s finances and revenue generating potential.
As we mentioned, tax obligations vary, which makes it difficult to gauge whether a company has more potential than another. EBIT allows us to compare similar companies that have differing tax obligations in any given industry.
It does this by stripping variables like capital structure and the tax burden, revealing whether or not the core operations of a company work as they should. “Working as they should” means that a business can pay its debts, fund day-to-day operations, and generate enough money to make a profit.
EBIT can also help shed light on innovative business ideas that are actually making money.
Lastly, EBIT is necessary if we want to calculate the interest coverage ratio, which we’ll look at below.
How To Calculate EBIT
When calculating EBIT, you subtract the cost of goods sold and operating expenses from total revenues. The formula is as follows:
EBIT = (Revenue) – (Cost of Goods Sold) – (Operating Expenses)
We can also calculate EBIT using this formula:
EBIT = (Net Income) + (Interest) + (Taxes)
What does EBITDA mean?
EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. Unlike the EBIT calculation, depreciation and amortization are removed when calculating EBITDA, meaning all non-cash expenses are removed from operating income.
Let’s take a look at the last two letters of the acronym to help us understand EBITDA.
Amortization & Depreciation
Amortization and depreciation refer to the reduction in value of fixed assets over time. The main difference between the two is that amortization is used for intangible assets, while depreciation is used for tangible assets.
What Does EBITDA Show?
The difference between EBIT and EBITDA is that if EBIT represents operating income, EBIDTA takes that one step further and represents cash flow generated by business operations.
It’s an alternative to metrics like revenue, earnings, or net income that is an excellent indicator of operational performance. By removing debt financing, EBIDTA can tell us how profitable a company is based solely on its fundamental operations.
Why Use EBITDA?
EBITDA is a great assessment tool that all small business owners should be aware of as they evaluate their company’s performance.
EBITDA removes non-operational decision factors that affect financial results, allowing us to get an accurate idea of how actual operating decisions affect a company’s finances. Basically, by removing certain unhelpful variables, you can get a more in-depth picture of a company’s health.
EBITDA has become commonplace among owners, buyers, and investors because it’s a useful metric for comparing business valuations.
As long as your financial information is accurate, calculating EBITDA is straightforward. It’s considered reliable by investors, though the Generally Accepted Accounting Principles, or GAAP, does not accept it. We’ll look at why below.
How to Calculate EBITDA
Like with EBIT, there are two formulas for calculating EBITDA. While they are different, each will give you the same result. They are:
EBITDA = (Net Profit) + (Interest) + (Taxes) + (Depreciation) + (Amortization)
EBITDA = (Operating Income) + (Depreciation) + (Amortization)
To correctly calculate EBITDA, it’s essential to have the full depreciation and amortization number. All of the information you need to complete either formula should be available on your balance sheet.
Accurate financial information is key to correctly calculating EBITDA—without it, your results will be inaccurate.
EBIT Coverage Ratio
Another useful metric, the interest coverage ratio measures the number of times a company could use its available earnings to make current interest payments. It’s mostly a way to gauge how much of a safety net a company has if they come upon hard times.
Since being able to make interest payments is a critical part of maintaining good financials, the interest coverage ratio is highly important.
To calculate the EBIT coverage ratio, you divide EBIT by the total interest expense. The formula is as follows:
Interest Coverage Ratio = (EBIT) / (Interest Expense)
Businesses should aim to have an interest coverage ratio above 2.0. An interest coverage ratio below 1.5 indicates that a company’s ability to pay interest expenses may be uncertain.
A poor EBITDA ratio can also mean the difference between qualifying for a small business loan or line of credit or not.
EBIT vs. EBITDA
The main difference when calculating EBITDA vs. EBIT is the number of steps used. So when should you use each one?
Since they tell us different things about operations, you’ll need to have an idea of what information is important to you. EBIT tells about the accrual basis results, whereas EBITDA provides an approximation of cash flow.
EBITDA is a good representation of cash flow in companies that have more or less low capital expenditures needed to fund their operations.
EBITDA is also used when investors need to assess a company for acquisition purposes, whereas EBIT is preferable in evaluating companies that have high capital expenditure.
EBIT and EBITDA Limitations
As we mentioned before, GAAP indicates that neither formula should be included in income statements. This is because these formulas don’t always give us the full picture, and companies sometimes use them to hide red flags.
As stated, for those businesses with high capital expenditure, like oil, gas, and mining companies, EBITDA fails to consider the capital expenditure necessary to sustain a business.
The amount of capital spending these businesses need put EBITDA and actual cash flow very far apart. EBIT is a better metric for high capital expenditure companies.
And by ignoring certain expenditures, companies can hide problem areas in their finances. Warren Buffett is an outspoken critic of EBITDA, saying that people use it to dress up their financial statements and that he wouldn’t buy companies using the formula in their annual report.
He also famously asked, “Does management think the tooth fairy pays for capital expenditure?” He was, in essence, criticizing that, although depreciation and amortization is not actual cash outflow, EBITDA is not giving us an accurate representation of financial performance.
Does EBITDA Have Other Uses?
Though we won’t go into them in great depth, you should know that the EBITDA formula has uses beyond what we’ve discussed in this article.
EBITDA figures prominently in some other useful calculations, which include:
- EBITDA margins, which is an assessment of a company’s operating profitability as a percentage of its total revenue
- EBITDA multiple, a financial ratio comparing a business’ enterprise value to its EBITDA to determine its value
Using EBIT and EBITDA in Your Business
Despite their limitations, EBIT and EBITDA remain useful tools for analyzing profitability and cash flow that entrepreneurs should be aware of as they plan for their company’s future.
The takeaway is that it’s not merely a matter of EBIT vs. EBITDA. It’s important to know not only the difference between the two, but that their significance goes beyond that. Business owners should familiarize themselves with all the ways they can use these practical tools to become a stronger, more efficient company.