Before you invest your money into a company, you’d like to know how profitable that business is compared to others, right? If investors fail to take metrics like the EBIT calculation into account when making investment decisions, they might not pick the best companies to support.
To find out what EBIT is, how to calculate it yourself, and how it can help in making investment decisions, keep reading.
What is EBIT?
Earnings Before Interest and Taxes or EBIT is a measurement found on a company’s income statement used to describe its profits before interest and taxes are taken into consideration (also known as its operating income).
When analyzing the overall health of a company, EBIT can be useful because it allows you to hone in just on the company’s earnings without looking at how things like taxes (which can vary widely from state to state or country to country) affect the final profit margin. This allows you to focus only on how the company itself is performing.
How can I calculate EBIT?
To figure out a company’s EBIT calculation, begin by reviewing its income statement. There you’ll find all the information you need to put together the formula to calculate the EBIT.
Before you determine the EBIT calculation, make sure you understand the following terms:
- Revenue — A business’s gross income or the total amount of money it made before subtracting any expenses.
- Business expenses — The costs associated with running a company, which may include marketing, transportation, rent, insurance fees, and more.
- Gross profit — A business’s profits calculated as revenue – cost of goods/services sold
Once you have a grasp of these terms, you can begin your EBIT calculation.
Using the income statement, first find the company’s revenue (how much the business made) and total up the business costs (e.g. the value of the goods they sold). Subtract costs from revenue to calculate gross profit. Next, subtract business expenses (e.g. marketing, transportation, or other costs) from the gross profit.
This value will result in the EBIT calculation, or the operating profit of the company before taxes and interest are taken into account.
EBIT calculation and investment decisions
Think of an EBIT calculation as the operating profit of the company. An “operating profit” is important to consider because it is one of the most accurate metrics used to examine a company’s profitability.
Taxes and interest rates can distort our understanding of a company’s profitability. Proponents of using the EBIT calculation contend that it’s a good way to understand a business’s profitability and cash flow. They’d argue that if we fail to take into account the impact of taxes and interest on a company’s earnings, we may accidentally invest in a less profitable company simply because we based our decision on the wrong measurement!
However, when making investment decisions, it’s important to use a variety of measures in order to gauge the financial health of companies that you might consider investing in.
While EBIT is a good way to understand operating profit, taxes and interest rates aren’t really avoidable costs. The EBIT calculation also doesn’t take into account the costs of depreciation and amortization (only EBITDA does that).
For these reasons, EBIT shouldn’t be used alone to determine a company’s profitability.
The EBIT calculation is one of many metrics of financial fitness that can be used to understand how profitable a company is before you decide to invest in it.
To learn more about how to make smart investing decisions, look around the FlexAcademy library.