In the business and finance world, there are two criteria that investors often use to evaluate a company’s worth. These are known as EBIT and EBITDA. They have important differences and are individually useful for calculating a firm’s operating profit. They’re also used as a good baseline for comparing the value of individual companies. What follows is a summary of both EDIT and EBITDA and what business owners need to know about each standard.
What Is EBIT?
EBIT stands for Earnings Before Interest and Taxes. In short, EBIT is essentially a company’s operating profit. It includes all expenditures except for income tax and interest and includes depreciation. EBIT is calculated using a simple formula:
- EBIT = operating revenue – operating expenses
Many accountants use the terms EBIT and operating profit interchangeably, and while this is generally acceptable, some experts warn against doing so because EBIT makes adjustments for values that are not included in operating income. When working with financial professionals, especially if they’re helping you evaluate an accommodation business for potential purchase, make sure you clarify whether they are using EBIT or general profit calculations.
What is EBITDA?
EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization, calculates a business’s net earnings before taxes, interest, depreciation and amortization are factored into the math. Financial analysts frequently use this calculation to make a decision that affects their day-to-day operation but doesn’t involve factors such as government tax rates or amortization.
When evaluating a company’s performance, investors can use the EBITDA value to compare similar companies across an industry and use it as a measure of profitability. It’s also helpful when comparing two companies in different tax situations, since taxes aren’t factored into the equation. While there’s no legal rule around EBITDA being reported, it can be easily calculated from figures found in a company’s financial statements using this formula:
- EBITDA = EBIT + depreciation + amortization
Here’s an oversimplified example: ABC Company makes $1,000,000 in sales revenue. After subtracting operating expenses, such as salaries for employees ($100,000) as well as rent and utilities (another $100,000) and depreciation ($50,000), the resulting value, $750,000, is considered the EBIT. Then, after interest is factored in, it drops to $700,000, which is the earnings before taxes. When taxes are subtracted, say $100,000, this results in a net income of $600,000.
From these values, we can calculate the EBITDA: We add the EBIT ($750,000) to the depreciation, $50,000, and any amortization, which in this simplified example, is zero. This results in an EBITDA of $800,000.
Limitations of EBITDA
EBITA is a popular value among companies that experience a lot of depreciation. These include telecommunications and utility companies. They provide services to their customers with high depreciation rates and large interests payments on debt. They rely on payments from their customers to keep them afloat, which leaves them with negative earnings. In this case, financial analysts use the EBITDA to determine earnings available for making debt payments.
Although EBITA is considered to be a wide indicator of performance, businesses should be careful in relying too much on the information it provides and proceed with caution. Here are a few reasons why:
- It’s not a substitute for cash flow. Taxes and interest require cash to pay, and leaving these items out of the equation doesn’t present a clear picture of earnings. Any business that’s not paying taxes isn’t going to be in business for long.
- It’s not suitable for companies with high amounts of debt, which skew the numbers.
- It doesn’t include capital expenditures (money that a business spends on equipment and tools in order to stay afloat).
The Big Picture
While values such as EBIT and EBITDA are important for companies to know, looking at the bigger picture of profitability is important as well. Knowing the actual cash flow, total debt payments, capital expenditures and net income provides a clearer picture of the overall financial stability of a business.
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