EBIT is the abbreviation of “Earnings before Interest and Tax” and is a very useful calculation for measuring a company’s performance. For many companies, EBIT can simply be their operating profit which can be found on the income statement. EBIT shows how profitable the company is from its operations and does not include expenses related to capital structure, such as interest and taxes. However, sometimes EBIT will not equal the operating profit. This is due to the company incurring expenses which are not part of their recurring operations. Therefore they will be added back to complete the EBIT calculation.
With this formula, the starting point is operating profit (found on the income statement). We start at this figure as we are only interested in the earnings before interest or tax, as these are fixed and not relevant when forecasting. Sometimes companies do not report operating profit. In this case, you will need to start from the reported net income figure and add back interest and tax. But, this will only provide you with operating income which may not be the same as the final EBIT figure that analysts are interested in. We need to consider any further adjustments which can be made to the operating profit figure.
Further steps needed to calculate EBIT?
As mentioned at the beginning, sometimes the operating profit of a company needs adjustments to get to EBIT. When stakeholders calculate EBIT, they are only interested in the earnings of the company which relates to its operations. Sometimes a company may incur an expense which is not part of its normal business but is still included in expenses, such as restructuring charges or impairments. This means that in order to calculate only the earnings generated from the business operations, any one-off expenses need to be added back on (one-off incomes or gains are deducted).
What one-off items need to be adjusted?
- Non-recurring expenses might include litigation, a one-off expense that has reduced the operating profit for the financial period.
- Non-core expenses could arise from the sale of a subsidiary, such as a gain on sale and costs directly associated with the sale.
- Non-controlled income is a result of ownership in another company (less than 50%). As this line item represents share of net income, it cannot be added to EBIT which is before interest and tax.
Why is EBIT a popular metric for analysis?
EBIT is a great tool to use as a performance indicator for a company. Stakeholders want to calculate the earnings a company generates from its operations. By looking at this, an investor can see how well run the company is (are costs too high? Profit margins relative to the sector?). Investors are interested in recurring financials which can be forecasted. It is also relatively easy to calculate which makes it a great asset when comparing different companies.
Example calculation of EBIT
Below are extracts from the financial statements of Tiffany & Co. Using the information provided, we will calculate EBIT for years 3, 4 and 5.
The income statement provides information on revenue and expenses throughout the financial period. We always start with the operating profit as reported on the income statement, in this example, the figure is called “earnings from operations”.
The next step is to go through the statement and search for any items above or below that we might want to strip out or add to arrive at a clean EBIT figure. One item stands out and is called “Arbitration award expense” with the amount of 480,211 in year 4. When coming across an unknown figure, it’s important to read through the footnotes in order to find out more information. The first note explains this charge, it was an expense in relation to a ruling which management didn’t think as probable. This immediately stands out as an expense which is not part of the normal operations of the business and does not appear to be recurring (it only happens in year 4). We, therefore, want to add this back to EBIT for year 4.
Another figure outlined in the footnote is in relation to an expense in year 3 under SG&A (selling, general and administrative expenses). The amount of 9,279 includes severance costs paid to staff. This is a non-recurring expense and because it was included in SG&A, we will add this back to operating profit.
Another figure which needs to be looked into is the “other income, net”. The line does not explain what this income is, we, therefore, need to read through the footnotes to examine this further. The footnote explains that the income is in relation to investing activities and foreign currency transactions. Whilst this is part of the normal operations of the business, it does not seem to relate to the company’s operating activities. We will, therefore, exclude this income in our calculation of EBIT.
Starting with the operating profit, it is now possible to make adjustments to arrive at EBIT. At first glance, it would be easy to assume Tiffany & Co had a very bad year in its operations. After a closer look, it’s easy to see that without this unexpected expense, the company’s earnings are much more realistic and follow a general upward trend.