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Wise investors prioritize a business’s stability, profitability, and sustainability before deciding to buy shares. The best way to do this: review the business’s annual income generation.
However, a company that makes enormous yearly income that grows steadily per year is a great choice. It’s easy to fixate a business’ ongoing interest rates and taxes with the problematic picture they present investors.
Experienced investors calculate earnings before interest and taxes (EBIT) to see the “raw” operation costs. Known as revenue minus expenses excluding tax and interest, you may also know EBIT as operating earnings or income, operating profit, and profit before interest and taxes.
It’s like a magnifying glass that looks deep beyond the capital systems and taxes a business faces to see their core operation’s income and expense flow.
In doing so, investors have the clearest picture of their true operating costs, allowing them to make an informed decision based on hard data supporting a business’s likelihood of sustainability and profitability.
What Is Earnings Before Interest and Taxes (EBIT)?
We all aspire to run our businesses someday. It’s essential to calculate amounts we earn before interest and taxes to know the time period we’ll need to scale our business through future equipment investments, branch openings, and more.
EBIT calculations make it easy to clear out unnecessary details, allowing us to see the full picture of our business’ monetary flow and total profitability. Investors aspire to help your business expand and become much more profitable than before.
However, they’ll want to know one thing: the total income you have before you deduct the loan and other financing interest rates you’re still paying. In doing so, they can assess your performance transparently.
How Do You Calculate for EBIT?
EBIT calculations include the raw materials businesses use to manufacture their goods or render their services. Any item that the business processes, combines, or develops into useful, branded products EBIT calculations consider as cost of goods sold (COGS).
To perform their processes, business establishments have numerous expenses, including the following:
- Equipment maintenance
- Equipment repairs
- Employee wages
- Additional knowledge ventures (seminars, review courses, etc.)
- Other non-financing and tax-related costs.
You can calculate a business’ EBIT if you have the following information:
- Total Profit
- Cost of Goods Sold (COGS)
- Net Profit
- Interest Expense
- All taxes the business handles
How to Calculate EBIT Based on Total Revenue
Businesses always record their most accurate calculation to ensure their EBIT calculations are accurate as possible. Additionally, accountants make sure to have every operating earnings and expense figure correct too.
Using total revenue, they use the following EBIT calculation:
EBIT = Revenue – COGS – Operating Expenses
The formula might seem simple, but most annual profit, non-operating income, COGS, and operating expenses have more than ten figures inclusive of decimals.
However, the calculation is straightforward and simple, allowing investors to calculate multiple businesses’ financial performances.
Here is a sample calculation to show it in action:
Business’ Profit: S $7,000,000 yearly
Total COGS: S $3,000,000
Operating Expenses: S $1,000,000
EBIT = S $7,000,000 – S $3,000,000 – S $1,000,000
EBIT = S $3,000,000 before interest and taxes
How to Calculate EBIT Based on Net Income
In some cases, you encounter the opposite figure. The business readily has its net income before interest and taxes (hence the name).
For this, the formula looks like the following.
EBIT = Net Income + Interest + Taxes
This bottom-up calculation uses available net income statement and then adds the current interest in any financing and taxes the business is currently handling.
For investors, EBIT shows the full picture of a business’ cash flow for a single year and determines the accuracy of net profit calculations, interest expense, operating profit, cost of goods sold, and overall company’s profitability.
Here is a sample calculation to show it in action:
Net Income: $ 5,000,000 yearly
Interest: Paid $ 500,000 for ongoing loan
Taxes: Paid S $850,000 (based on the 17% Singapore corporate tax rate)
Earnings Before Interest and Taxes: S $5,000,000 + S $500,000 + $850,000
EBIT = S $6,350,000
Why Does It Help to Calculate Earnings Before Taxes (EBT)?
EBT focuses on the total gross profit a business has accomplished in a specific period. Its formula is as follows:
EBT = Revenue – COGS
It helps calculate this figure to give investors an idea about the business’ overall profitability using sales as its yardstick. Its significant difference with the EBIT formula is the lack of operating costs in the equation.
Sales revenue before tax allow investors to evaluate any company’s performance without cluttered tax rates and other unnecessary elements.
EBIT Isn’t The Same as Operating Income
Operating income is different from EBIT and EBT. It focuses on isolating the total operating costs versus the business’ gross income. In doing so, investors have a clear picture of a business’s operating efficiency, which the EBIT formula, EBT, and EBITDA cannot illustrate effectively.
To calculate operating income, you can use the following formula:
Operating Income = Gross Income – Operating Costs
Income reports completely detail a business’s operating income and EBT, which signifies transparency and reliability for many investors. Truthfully, business owners can suffer massive penalties for inaccurate income reports involving operating income.
The fines are hefty enough to drive them to bankruptcy and eventual liquidation.
Calculating Break-Even EBIT
EBIT is an investor’s tool to learn about a business’ profitability through their income before adding in taxes and interests. Break-even EBIT is a figure allowing them to discover the impact of different financing plans on the business, which you can measure through earnings-per-share (EPS).
Any business’ goal is to have a higher EPS than its previous evaluation, allowing EBIT to grow higher than the break-even EBIT value. Having a higher than break-even EBIT value than before makes them much more appealing to future investors.
To calculate this value, you can use the following formula:
Break-Even EBIT: (EBIT – Interest Expense) x (1.0 – Tax Rate Formula)/Equity Number of Shares
EPS is a benchmark giving business owners insight about their overall market value if they’re a publicly-listed business. Therefore, a higher EPS is highly likely to attract substantial investors and encourage existing investors to take up more available shares in the process.
The formula deducts interest from EBIT. Then, you can derive your tax rate formula by dividing income tax expenses by your earnings, which we can illustrate in this equation:
Tax Rate Formula = Income tax expenses/ earnings or gross income
Lastly, the equity number of shares is your business’ total or estimated number of shares from private investors.
These values change daily, but the average value of equity shares in a particular period gives you a “snapshot” value of break-even EBIT, allowing investors and business owners to find the best options.
The Major Differences Between EBIT and EBITDA
Depreciation & amortization are two factors businesses accrue that affect their gross earnings and overall profitability. They have a significant effect on earnings before interest and taxes.
Depreciation: The total value an asset or business loses over time
Amortization: A business’ cost to run and maintain versus its usefulness or overall profitability
Investors use EBITDA to determine the business’s possible future profitability. Wise investors make sure they’re spending money on companies with long-term sustainability.
The business’ facilities, equipment, and employee knowledge, experience, and education affect depreciation and amortization.
We can sum it up in this formula:
EBITDA = Operating Income + Depreciation + Amortization
Truthfully, no method exists to improve depreciation and amortization except to invest in new facilities, equipment, and personnel once both factors reach their critical point.
For business owners, a good rule of thumb is to change their equipment once the repair or maintenance costs have gone beyond 50% of the total value of a new, upgraded equipment version.
EBITDA is an improved EBIT formula because it removes both depreciation and amortization from the equation. A normal EBIT equation always includes depreciation in revenue values.
By removing both depreciation and amortization, investors have a clearer picture of the overall business performance based on operating costs and actual earnings alone.
The biggest mistake beginner investors make is viewing only the ongoing high debt and taxes the business is paying concerning their profit.
However, with EBIT, they get the total income and profit-generating capacity of a prospect business independent of their debt, taxes, depreciation, and amortization values.
Truthfully, a business’s profitability relies greatly on the cost of goods sold and operating costs, which the EBIT calculation already achieves.
However, some investors and accountants find it better to remove both depreciation and amortization to reveal a prospect business’ “purest” profit value. In doing so, investors can make an objective and fully informed decision.
All Investors Use EBIT Calculations To Make The Best Investment Decisions
As an investor, learning a business’s overall capital structure should play a huge role in your investment decisions. These equations are useful to prevent investors from relying heavily on trends, especially for short-term investors looking to make immediate profits.
Riding on trends became many investors’ profit loss actions. With proper data, you can make the best decisions that remove debt, taxes, depreciation, and amortization. Doing so allows you to see the tools and resources at the business’ disposal to recover and create lasting value once again.