Understanding EBIT (Earnings Before Interest and Taxes) and How to Calculate EBIT – EBIT is an abbreviation of Earnings Before Interest and Taxes. Basically, EBIT or Income before Interest and Tax is a profitability measurement that calculates a company’s operating profit by reducing the cost of selling goods and operating costs from total revenue.
EBIT or income before interest and tax is also often referred to as Operating Income. This calculation shows how much profit the company makes from its own operations without regard to interest and taxes. Therefore, EBIT calculation is also often referred to as operating profit.
Please to also read Definition of Profitability Ratio Analysis and Types.
Investors and creditors use EBIT calculation to see the condition of the company’s core business operations without having to worry about the consequences of payments or interest costs.
With EBIT calculation, Investors and Creditors can assess whether the company’s business activities can be carried out effectively. This calculation can also help creditors and investors understand the company’s health and the company’s ability to pay its obligations.
How to calculate Earnings Before Interest and Taxes (EBIT)
The following are the Formulas for Calculating EBIT and Case Examples.
The formula for Calculating EBIT
There are two types of formulas for calculating EBIT, namely the formula for calculating EBIT by the direct method and the formula for calculating EBIT by the indirect method.
The formula for Calculating EBIT with the Direct Method
The first method is a direct method calculated by subtracting the cost of goods sold and operating costs from total revenue.
EBIT = Total Sales – Cost of Sales – Operating Costs
The formula for Calculating EBIT with the Indirect Method
The second method is an indirect method that adds tax and interest to net income.
EBIT = Net Profit + Tax + Interest
As we can see, the two calculations above are very simple calculations. The first formula shows us directly what should be excluded from total revenue while the second formula shows us what needs to be added back to net income. These two formulas give us a better understanding of two different points of view. The first is from an initial operating point of view while the second is from a year-end profitability perspective. But both get the same results.
Example Case Calculation of EBIT (Earnings Before Interest and Taxes)
A computer parts supplier company reports 2014 earnings reports as follows:
- Sales: $ 2,000,000 –
- COGS (Cost Of Goods Sold): $ 1,300,000
- Gross Profit: $ 700,000
- Operational Costs: $ 400,000
- Interest Cost: $ 100,000
- Income Tax: $ 20,000
- Net Profit: $ 180,000
- EBIT = Net Profit + Tax + Interest
- EBIT = 180,000 + 20,000 + 100,000
- EBIT = 300,000
So the income before tax and interest or the company’s EBIT is $ 300,000. This means that the company has a profit of $ 300,000 left after all the Cost of Goods Sold (COGS) and operational costs paid in 2016. The remaining money is $ 300,000 can be used to pay bank interest, taxes, investor dividends, or to pay debts.
EBIT Calculation Analysis
Although it looks simple in its calculations, yet EBIT calculation can provide important information about the company’s financial position without taking into account the company’s financing structure. By looking at operating profit (not net income), we can evaluate how profitable a company’s operations are without taking into account the cost of debt or interest expense.
Investors generally use this EBIT metric to compare two or more different companies in order to find out how efficient a company’s operations are without considering to the company’s obligations such as interest and tax expenses.
As an example in company A and company B, the companies reported a net profit of $ 20 million and $ 18 million. Without looking at EBIT metrics, we will consider company A to be more efficient in its operational activities and also more profitable.
But if we include the loan interest element, then each of which has an interest expense of $ 2 million and $ 7 million, it will be seen that company B has higher leverage when compared to company A. When viewed in terms of the profitability of business operations, we can be sure that Company B is better than Company A.