Earnings Before Interest and Taxes: Explained
Analysts use different methods of evaluating company performance. Earnings before interest and taxes (EBIT) is an accounting measure that describes core profitability.
What Is Earnings Before Interest And Taxes?
Earnings before interest and taxes is a profitability measure calculated as revenue minus expenses, before taxes and interest. These expenses include operating expenses, such as salary, utilities, and insurances. Thus: EBIT = Revenue – Operating Expenses. Furthermore, one sees that this measures a company’s efficiency of operation. These expenses are unavoidable. For example, net income measures the amount of revenue left after deducting all expenses. Theoretically, some of these expenses are one time, such as a large interest payment that will not recur in the future. EBIT, however, focuses only on core business operations and does not penalize one-off payments.
Also, earnings before interest and taxes ignores a company’s capital structure. This is significant because creative accounting or advantageous capital structure skews net income numbers.
Using EBIT In Analysis
Analysts and investors alike use relative valuation in making investments or recommendations. For example, companies in similar industries both report similar income numbers, but this does not tell the whole story. The companies most likely have different tax burdens or capital structure. Comparing their earnings side by side a fatal mistake.
However, using a measure such as EBIT removes the variability and ensures sound comparison. Additionally, an investor looking to purchase an entire company looks at earnings before interest and taxes rather than net income. This is because investors concern themselves with future earnings and not capital structure.
It is important to note that interest extended to customers as the result of a sale does not qualify for EBIT, and is left in the number. Interest from loans, such as bond payments qualifies.
Earnings before interest and taxes is yet another profitability measure which interested parties use to value companies. Different sectors weigh different measures more than others. EBIT is a sound method of evaluating companies in similar businesses of most tangible goods producing companies.