Earnings before interest and taxes - EBIT definition
/What is Earnings Before Interest and Taxes?
Earnings before interest and taxes is a calculation of the operating earnings of a business. It specifically excludes interest, which is a finance cost, and taxes, which are imposed by a governmental entity. The residual amount is a fair approximation of the current earning power of the operations of a business. The concept is more commonly known by its acronym, which is EBIT.
The use of EBIT is common among industry analysts, because they can use it to ignore the financial effects of the differing capital structures of entities within an industry, and focus on their operational results instead. Similarly, it can be used to ignore the differing tax situations of comparison companies, who may have different effective tax rates, depending on their tax planning activities.
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Formula for Earnings Before Interest and Taxes
To calculate EBIT, subtract interest expense and income tax expense from net profit. The interest expense should include all interest charges associated with any type of debt, which includes lines of credit, short-term debt, and long-term debt. The EBIT formula is as follows:
Net profit - interest expense - income tax expense = EBIT
The concept should be expanded to also exclude interest income, since this is also not related to operations. Otherwise, a business with a large amount of investments would report an excessive amount of income, rendering its results not comparable to those of similar companies. This situation is most likely to arise for a business that has recently gone public and sold a large amount of stock, resulting in an inordinately large bank balance.
Problems with Earnings Before Interest and Taxes
A key failing of the EBIT concept is that a company may have gone to a considerable amount of trouble to gain a long-term advantage by reducing its tax burden. This is typically done by setting up operations in countries that charge a lower income tax rate. If so, this could be considered a result of the operational activities of the business. This argument implies that taxes should be considered part of operations.
A publicly-held entity may be tempted to report its EBIT in its reporting to the investment community. This is not encouraged by the Securities and Exchange Commission, which mandates that the reporting of any non-GAAP financial measure must be reconciled back to an appropriate GAAP measure (such as net profits).