There are quite a few tests, formulas and ratios that investors use to decide where to put their investment funds. These tools allow the investor to objectively compare several investment options with the objective of determining which is likely to give a better return on investment; one such tool is EBIT.
How to Calculate EBIT/The EBIT Formula
EBIT is also referred to as “operating earnings”, “operating profit” and “operating income”. It is calculated by subtracting operating expenses from revenue, excluding tax and interest payments. The formula is:
EBIT = Revenue – Operating Expenses
Because EBIT does not take into account taxation and interest payments on liabilities it is a good way of comparing companies in terms of which is more profitable without distorting those figures with the effect financial leveraging or taxation. However, using EBIT as the sole test to make an investment decision has its pitfalls.
Pitfalls to Avoid
Even though EBIT is a good measure of profitability, it is not a complete analytical tool, in part because it does not take into account the effect of taxation and the cost of debt financing, and how these will affect the company’s profitability. For sure, interest payments and taxation will reduce profitability.
For example, if company A is more profitable and efficient that company B, but company B is enjoying a tax holiday, the latter may be a better investment despite the fact that it is less profitable, at least for the short to medium term while the tax holiday is being enjoyed. It is a similar situation as far as interest payments are concerned. If a company is highly leveraged (has significant amounts of debt) the interest payments on its debts can negatively affect profitability and by extension how attractive the company is as an investment vehicles.
Investing in a debt laden company is not the first choice of any level headed investor, and the investment is even less attractive if that company falls into a high percentage tax bracket.
Earnings before interest tax ebit (EBIT) is a good number for measuring profitability and comparing dissimilar investment options. Even so, it can overlook certain important considerations that may disqualify an investment as a good. Therefore the investor must take into consideration the effects that interest payments and taxation may have on the amount of profit that will be left to be redistributed to investors or reinvested in operations.
“earnings before interest tax ebit.” Phillip Put