EBIT or EBITDA: Scratching your head right about now?
Of the many acronyms small business owners have to keep in mind, these two rank high on the list and there are some important distinctions between them.
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. (We’ll review EBIT and EBITDA formulas, too.)
What Does EBIT Mean vs. EBITDA?
EBIT stands for earnings before interest and taxes, also sometimes referred to as operating income.
EBITDA stands for earnings before interest, taxes, depreciation and amortization.
Let’s take a look at what these acronyms mean to help you better understand EBIT vs. EBITDA.
Earnings refer to net income or the bottom line. Knowing how much earnings your company generates is crucial.
Interest includes any interest payments you make on credit or loans.
The tax part of EBIT and EBITDA comprises whatever dollar value your company must pay in federal and state taxes as stated by the law.
Depreciation refers to the reduction in value of fixed assets over time. Only tangible assets depreciate.
Amortization also refers to the reduction in value of fixed assets over time. Unlike depreciation, amortization is used for intangible assets.
What Does EBIT Show?
EBIT is used as a profitability measurement. Calculating earnings before interest and taxes is preferable in evaluating companies that have high capital expenditure. By removing interest and taxes, a clearer picture emerges regarding the profit a company makes solely based on its operations.
If you’re wondering, “Does EBIT include depreciation?” The answer is no.
Why Use EBIT?
EBIT allows investors a different perspective on a company’s finances and revenue-generating potential.
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 different tax obligations in any given industry.
It does this by stripping variables like debt, equity and taxes, revealing whether or not the core operations of a company are able to generate earnings, which can provide insight into whether a business can pay its debts, fund day-to-day operations and make a profit.
EBIT can also help shed light on innovative business ideas that are actually making money.
Formulas to Calculate the EBIT
The formula to calculate the EBIT requires you to subtract the cost of goods sold and operating expenses from total revenues.
The formula for earnings before interest and taxes is as follows:
EBIT = (Revenue) – (Cost of Goods Sold) – (Operating Expenses)
We also can calculate EBIT using this formula:
EBIT = (Net Income) + (Interest) + (Taxes)
What Does EBITDA Show?
EBITDA is an indicator of financial performance and can tell us how profitable a company is based solely on its fundamental operations. It’s also a good representation of cash flow in companies that have more or less low capital expenditures needed to fund their operations.
Here’s the difference between EBIT and EBITDA: If EBIT represents operating income, EBITDA takes that one step further and represents cash flow generated by business operations.
Why Use EBITDA?
A metric of profitability, EBITDA excludes nonoperating expenses and certain noncash expenses, such as debt financing and intangible assets, allowing us to get a better idea of how actual operating decisions affect a company’s finances.
EBITDA has become commonplace among owners, buyers and investors because it’s a useful metric for comparing business valuations. EBITDA also is used when investors need to assess a company for acquisition purposes
As long as your financial information is accurate, calculating EBITDA is straightforward.
Formulas to Calculate the EBITDA
As with EBIT, there are two formulas to calculate EBITDA. While they are different, each will give you the same result. The formulas for calculating Earnings Before Interest, Taxes, Depreciation and Amortization include:
EBITDA = (Net Income) + (Interest) + (Taxes) + (Depreciation) + (Amortization)
EBITDA = (Operating Profit) + (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.
EBIT vs. EBITDA Limitations
Fair warning: While EBIT and EBITDA are considered reliable by investors, the Generally Accepted Accounting Principles (GAAP), doesn’t consider them standard measures for financial reporting. This is because these formulas don’t always give us the full picture, and companies sometimes use them to hide red flags.
For businesses with high capital expenditures such as 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 puts EBITDA and actual cash flow very far apart. EBIT may be a better metric for high capital expenditure companies.
And by ignoring certain expenditures, companies can hide problem areas in their finances. Billionaire investor 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 that use the formula in their annual reports.
Use EBIT and EBITDA in Your Business
Despite their limitations, EBIT and EBITDA are useful tools for analyzing profitability and cash flow. They can help you plan for your company’s future.
EBIT vs. EBITDA: Put these metrics of performance to good use.