These are uncertain times for stock market investors. All three major stock market indices are in the midst of a correction. Adding more risk to the global economy is the ongoing coronavirus pandemic.
In fact, Wall Street’s fear index hit its apex of 83 during March. This was even higher than the peak during the Great Recession in 2008. With so much uncertainty on Wall Street, it is more important than ever to review a company’s fundamentals.
One of the best indicators of corporate strength is earnings before interest and taxes (EBIT). Read on to learn how to calculate this earnings metric. Explore related topics like its definition and why this metric is so important.
What Is the Definition of EBIT?
Earnings before interest and taxes are a means to determine a company’s profitability. More specifically, the metric places emphasis on the company’s operating profit.
It achieves this focus by removing non-operating expenses. These include interest charges and taxes assessed by federal and state governments.
How to Calculate EBIT
The calculation is fairly simple to understand. There are two different ways to calculate earnings before interest and taxes.
For the first method, the starting point is quarterly or annual revenue. You can find this figure on a revenue statement. Next, subtract the cost of goods sold and any operating expenses.
The second method begins with net income. This figure can be found on an income statement. Then you simply add interest charges and taxes assessed.
Why Is It Valuable?
The earnings before interest and taxes metric is a valuable tool in the business community. Ease of calculation is one of the primary reasons that experts use it. You can quickly assess a company’s operating profitability using addition or subtraction.
All you need is a few reporting figures that are readily available on basic financial documents. Another reason for its popularity is that it allows for apples to apples comparison. The financial data is normalized by focusing only on the business’s operations.
For investors and entrepreneurs, they can now compare different companies against each other. Tax policy can change depending on the political party winning elections. A politician may increase taxes only to be replaced years later by a tax-friendly administration.
Therefore, taxes may cloud the results of your financial assessment. A low tax rate could mask operational issues if you do not perform an EBIT calculation.
The bottom line is that earnings before interest and taxes allow you to assess a company’s profitability. Does the company earn enough money to be profitable? Can they continue to fund their business?
What Is an Example of Using EBIT for Comparative Purposes?
Now we will help you understand the value of comparing companies using earnings before interest and taxes. This metric normalizes data for companies with a high proportion of debt. Many people think of debt in a negative light.
However, in the business world, debt is a necessary evil, especially in certain industries. Some industries, such as energy, depend on debt in order to succeed. They finance large facilities and equipment such as processing facilities or oil rigs.
These items cannot easily be purchased with cash assets. Instead, they are financed and the price of these fixed assets is spread out over a loan term. The result is high-interest expenses.
The interest is pivotal to the long-term operability of the business. These energy companies purchase new equipment and physical property as their output grows. Comparing the net income of ExxonMobil to an entertainment company is not a good analysis. Instead, you can remove interest expenses and focus on operating earnings.
What Is EBITDA?
There is a variation of the earnings before interest and taxes calculation that goes one step further. Known as EBITDA, this equation makes an adjustment for depreciation and amortization. Continue reading on for a brief explanation of these two adjustments:
Depreciation is a reduction in asset value over time. Capital equipment is subjected to wear and tear, which results in a reduced appraisal value. Like interest expenses and taxes, depreciation is easy to find. It is reported on a company’s income statement.
Because no cash is transferred when an asset depreciates, it is listed as a non-cash expense. As discussed earlier with energy companies, many industries rely on capital equipment to operate. They incur significant expense to purchase it.
However, physical property and equipment retain residual value. They are assets to the company and can be resold at the depreciated price.
It would not portray an accurate representation of the company’s earnings to fully expense physical property and equipment. Instead, companies spread the expense out over several years and consider it depreciation.
The next adjustment is referred to as amortization. This is another non-cash expense like depreciation. Amortization is an accounting technique that is used to write down the value of a loan or physical asset.
Here, you amortize the expense over the life of the asset. This is another technique that increases profitability. Adjusting for amortization gives financial experts an even closer look at operating profit.
Amortization sounds very similar to depreciation and is calculated the same way. One difference is that amortization is used on more items than just physical property or equipment. It can be used on items like a patent or copyright.
Are There Any Concerns With Using These Metrics?
It would be ill-advised to solely using one of these financial metrics. First off, neither metric is recognized as a Generally Acceptable Accounting Principles (GAAP).
Next, each one is subject to manipulation. This is not intended to dissuade you from using earnings before interest and taxes. Instead, you should use it in conjunction with other metrics like free cash flow and net income.
What Comes Next?
Earnings before interest and taxes is a valuable calculation used to review businesses of any size. It allows for laser focus on a company’s operating profit. It makes adjustments for items that can skew a financial analysis, like interest and taxes.
If you have any questions about EBIT, contact us today for additional guidance.