“We are trying to look at businesses in terms of what kind of cash can they produce, if we’re buying all of them, or will they produce, if we’re buying part of them.” – Warren Buffett
Cash flows remain the lifeblood of every company. And the starting point for those cash flows is earnings before interest and taxes or EBIT.
Great fundamental investors focus on determining the sustainability of free cash flow. And these cash flows stem from every business’s revenues, costs, and operating costs.
Cash flows originate from facts, cash in and out, where earnings or net profit can have different interpretations. And the cash flows help determine a company’s long-term value.
But earnings before interest and taxes remain the foundation of it all.
In today’s post, we will learn:
- What is EBIT or Earnings Before Interest and Taxes (EBIT)?
- How Do We Calculate for Earnings Before Interest and Taxes
- How Can We Use EBIT or Earnings Before Interest and Taxes?
- Limitations of EBIT
- Real-World Examples of Earnings Before Interest and Taxes
Okay, let’s dive in and learn more about earnings before interest and taxes. Before we start, earnings before interest and taxes are a mouthful, so for the rest of the article, we will refer to it as EBIT as it fits.
What is Earnings Before Interest and Taxes (EBIT)?
EBIT, or earnings before interest and taxes, measures how profitable a business is. Revenue minus expenses, without taxes and interest, is EBIT. Other names for EBIT are operating earnings, operating profit, and profit before interest and taxes.
EBIT measures an organization’s operating profit and is often used interchangeably with operating profit. EBIT ignores factors like taxes and capital structure. Instead, EBIT focuses only on a company’s capacity to create earnings from operations.
Because it helps to determine a company’s capacity to produce enough earnings:
- to be profitable
- pay off debt
- and fund continuous operations
Because of the above reasons, EBIT remains a particularly helpful indicator.
Investors comparing companies with various tax conditions might also enjoy using EBIT. For example, if an investor wants to buy a company, they can use EBIT to measure the operating profit, excluding taxes. The company’s net income or profit would rise if it recently received a tax break or reduced corporation taxes in the US.
The advantages of the tax cut are still excluded from the analysis using EBIT. Using EBIT, investors can compare businesses in the same industry but with various tax rates.
EBIT is useful for examining businesses in capital-intensive sectors with a high proportion of fixed assets on their balance sheets.
We can consider fixed assets such as physical property, plant, and equipment part of those assets. Companies tend to finance these types of assets with debt.
For instance, businesses in the oil and gas sector need a lot of cash since they must finance their drilling machinery and oil rigs.
As a result of having a large amount of debt on their balance sheets, capital-intensive sectors have high-interest costs.
However, debt is essential for the long-term expansion of businesses in the sector if handled well.
Compared to other businesses, those in capital-intensive industries may have more or less debt. As a result, the companies’ interest expenses would differ when compared to one another.
EBIT helps investors evaluate the operations and earnings potential of a company. By excluding debt and interest expenses, EBIT allows apple-to-apple comparisons.
How Do We Calculate Earnings Before Interest and Taxes
The formula for calculating or determining EBIT is simple and straightforward. We have two ways to find the same number.
EBIT = Revenue – COGS – Operating Expenses
EBIT = Net Income + Taxes + Interest
- COGS equals the costs of goods sold.
Let’s unpack the calculations a little bit.
The EBIT calculations take into account all the costs connected with generating revenue. It includes items such as:
- raw materials
- stock-based compensation
- depreciation and amortization
- many more
The formula then subtracts all those costs from the revenue to arrive at EBIT.
Here are the steps:
- Find the revenue or sales from the top line of the income statement.
- Subtract the cost of goods sold (COGS) from the revenue, giving us gross profit.
- Subtract the operating expenses from gross profit, and voila, EBIT.
Now the fun part, we will rarely have to do this calculation. Most, not all, companies calculate EBIT or earnings before interest and taxes for us. You will, from time to time, encounter a company that lumps all the costs together, excluding gross profit. But these examples remain rare.
Some businesses label EBIT as operating income.
We will also see businesses with different labels in different industries, such as banks or insurance companies. For example, JP Morgan doesn’t have EBIT on their income statement. Instead, they have a line item labeled Income Before Income Tax Expense.
They do this because they generate revenues from a different business model and must arrange their income statement differently.
Insurance companies such as Progressive also have the same line item.
These little tips will help you understand the different business models and how we can apply our learning to different companies.
How Can We Use EBIT or Earnings Before Interest and Taxes?
The easiest way to explain EBIT is to use an example. Let’s say we want to invest in Microsoft. After looking at their year-end financials or 10k, we see:
- Revenues = $198,270 million
- Cost of goods sold = $62,650 million
- Gross profit = $135,620 million
Microsoft’s gross profit equals $135+ million before subtracting the company’s operating expenses. Microsoft lists the following operating expenses on its income statement:
- R&D expenses = $24,512 million
- Selling, General, & Administrative expenses = $27,725
We can determine Microsoft’s operating income by subtracting the gross profit from the individual operating expenses.
Microsoft EBIT = $135,620 – $24,512 – $27,725 = $83,383
As mentioned above, we have many different ways to calculate EBIT. But it is not a GAAP metric, and most companies don’t label it as such. Most companies label it as operating profits or earnings before interest and taxes.
The main way to determine EBIT remains to start with revenue or total sales as the base.
We then subtract the cost of goods sold and operating expenses. We can remove any one-time or extraordinary items, for example, revenue from a divestiture or lawsuit. These revenues or expenses don’t relate to the operations of Microsoft.
We also exclude non-operating income, such as revenue from investments. We also exclude expenses from derivatives too.
By excluding these items, we set EBIT apart from operating income.
Some businesses include interest revenue in EBIT; however, depending on its source, others may not. This interest income is a part of operating income and is always included by a firm if it lends credit to its clients as a fundamental aspect of its business.
On the other hand, we can disregard interest income if it comes from investments in bonds or from charging late payment penalties to customers.
This modification is at the investor’s discretion and should be used consistently across all companies being compared, just like the other ones stated.
We can also take net income (profit) from the income statement or top line. And add the income tax expense and interest expense. By adding these back to net income, we arrive at EBIT.
Earnings Before Interest and Taxes is a useful metric for investors for two reasons: (1) it’s simple to calculate, and (2) it makes comparing companies simple.
- Since the income statement breaks out net income, interest, and taxes, using the income statement as a calculator is quite simple.
- It normalizes profits for the company’s capital structure (by adding interest expense back in) and the tax structure it is subject to. The reasoning is that a business owner could alter the company’s capital structure (hence adjusting for it) and relocate the headquarters to a location with a different tax structure. These assumptions are both conceivable in theory, though it is debatable whether they are feasible.
Limitations of EBIT
Depreciation is a factor in the EBIT calculation and can produce different results when comparing businesses in other industries.
Depreciation costs would be detrimental to the company with fixed assets if an investor compared it to a company with fewer fixed assets because the expense lowers net income or profit.
EBIT is an organization’s operating profit, excluding taxes and interest costs. When determining profitability, EBITDA (earnings before interest, taxes, depreciation, and amortization) takes EBIT and eliminates depreciation and amortization costs. EBITDA doesn’t include taxes and loan interest costs in EBITDA like EBIT. But EBIT and EBITDA differ from one another.
Companies with a sizable number of fixed assets can amortize the acquisition cost over the assets’ useful lives. Depreciation, in other words, enables a business to spread out the expense of an asset over a long period or the item’s lifetime.
Using depreciation, a business can avoid recording the asset’s cost in the year it purchased the asset. Depreciation costs consequently impact profitability.
Depreciation costs can affect net income or the bottom line for businesses with many fixed assets. EBITDA calculates a company’s earnings after subtracting depreciation. EBITDA hence aids in getting to the bottom of a company’s operational performance profitability.
Both EBIT and EBITDA have advantages and applications in financial research.
Additionally, businesses with a lot of debt will incur many interest expenses. EBIT reduces interest costs and boosts a company’s potential for profits, especially if it has a high debt load. Failing to include debt in the study may prove troublesome if the company raises its debt level due to a lack of cash flow or subpar sales performance.
When examining a company’s financials, it is crucial to remember that in a rising rate environment, interest expenses will increase for businesses with debt on their balance sheets.
Real-World Examples of Earnings Before Interest and Taxes
For example, we have Google’s latest 10-k income statement ending 12-31-2021 (all figures in millions unless otherwise noted).
Google breaks its income statement up a bit differently. Instead of breaking the cost of revenues down and calculating a gross profit, they include all costs to determine income from operations or EBIT.
To calculate Google’s EBIT, we subtract from net sales the following numbers:
- Cost of revenues – $110,939
- Research and development – $31,562
- Sales and marketing – $22,912
- General and administrative – $13,510
- European Commission fines – $0
Notice the deviation from the “normal” income statement line items and European Commission fines. In 2019 the company paid $1.6 billion in fines to the European Commission for antitrust rules violations. Notice it has not paid any since 2019 and will fall off in the next filing.
We can calculate EBIT by subtracting the above values from the revenues:
Total costs & Expenses
Income from Operations
As we can see, Google demonstrates tremendous operational efficiency. We can calculate both gross profit and operating profit for the company like this:
- Revenues – $257,637
- Cost of revenues – $110,939
- Gross profit – $146,698
- Gross profit margin = $257,637 ÷ $146,698 = 56.94%
And their operating efficiency as such:
- Gross profit = $146,698
- Research & Development – $31,562
- Sales & Marketing – $22,912
- General & Administrative – $13,510
- Total operating costs = $67,984
- EBIT = $146,698 – $67,984 = $78,714
- Operating profit = $257,637 ÷ $78,714 = 30.55%
Doing exercises like these is a great practice to get a feel for the inputs and margins a company generates. You can also find these ratios and margins on your favorite financial website. But doing a little math now and then won’t hurt you.
Another great practice is to look at a company’s margins over longer periods, such as five to ten years. The longer, the better, as it gives you insight into any operational leverage and long-term impacts of managerial direction.
EBIT is a crucial indicator of a company’s operational effectiveness. It demonstrates how much a company makes from its core operations because it doesn’t include indirect costs like taxes and interest on debts.
For me, EBIT, or earnings before interest and taxes, remains the most important line item on the income statement. I feel this for several reasons; one, it helps us determine how profitable the company’s operations are and how well a company uses its costs to drive profit. Second, it is a direct line to free cash flow for a company, which IS the most important measure of company value.
For these reasons, EBIT offers me the best insight into the operations of Google and how well they operate.
And with that, we will wrap up our discussion concerning earnings before interest and taxes or EBIT.
Thank you for taking the time to read today’s post, and I hope you find something of value. If I can be of any further assistance, please don’t hesitate to reach out.
Until next time, take care and stay safe out there,