Understanding EBIT vs. EBITDA: Differences in Credit Risk Analysis

Understanding EBIT vs. EBITDA: Differences in Credit Risk Analysis
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EBIT and EBITDA Connection

In determining the differences between EBIT vs. EBITDA, we deem it best to go back to the traditional EBIT, which is Earnings before Income Tax, the conventional method of income statement presentation. Interests on deposit accounts rarely make any impact as far as materiality is concerned, due to low interest rates and the fact that checking accounts generally do not earn interest at all.

However, the offshoot of this concept, which is the EBITDA, takes into account the interest earnings on deposit as essential in a quick view of the actual cash position of a company. This is in the event that the interest earned does create a significant impact in the cash position. In a lending transaction, the proceeds of substantial loans granted will form a large part of the borrower’s interest-earning deposit; thus, interest earned should be excluded as part of cash projections.

In time, EBIT generally has stood for Earnings Before Interest and Taxes, which eliminated one of its main differences against EBITDA, as this stands for Earnings Before Interests, Taxes, Depreciation and Amortization.

The following section is a reference to the Securities and Exchange Commission’s (SEC) views about these two concepts as points of comparisons. Both financial tools relate to presentation of income, and it is common knowledge that the SEC is quite particular about income or profitability presentations.

SEC Position on EBIT and EBITDA

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Item 10(e) of SEC Regulation S-K prohibits adjusting a non-GAAP performance measure to eliminate items identified as non-recurring, if the nature of the charges or gains are likely to recur within two years or if similar charges or gains were recognized within the prior two years.

EBIT and EBITDA are considered as non-GAAP performance measures, in which exclusions will be exempted from the prohibition, if the charges or gains excluded require cash settlement.

This then will bring us back to the traditional EBIT which is Earnings Before Income Tax, which qualifies for exemption of the prohibition of Item 10(e) of SEC Regulation S-K, since income tax requires cash settlement. Nevertheless, interest on deposits also involves cash increments; hence, this exclusion still qualifies as acceptable for a non-GAAP performance measure.

In contrast, the EBITDA concept excludes depreciation and amortization charges that recur within two years and are mandated as valuation tools. In addition, they are book entries and do not require cash settlement. EBITDA, therefore, is a non-GAAP performance measurement, generally not qualified for exemption to the prohibition of the said SEC rule.

The prohibition largely supports the non-recommendation of EBITDA as a basis for evaluating the performance of publicly traded companies.

Choosing between EBIT vs. EBITDA for Credit Risk Analysis

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The remaining difference between these two concepts is the exclusion of depreciation and amortization charges. See separate articles entitled How to Calculate EBIT and Explaining EBITDA Calculation and Examples of Its Uses for Credit Risk Analysis, for more explanations and examples of their individual uses as credit tools.

The following are significant differences in comparing certain EBIT vs. EBITDA aspects of credit risk analysis, where one excludes depreciation and amortization while the other does not.

Which Projection is More Conservative?

EBIT takes on a more conservative outlook in the measure of cash position over EBITDA, because it does not add back depreciation and amortization charges in estimating the company’s available cash funds. This silently increases the margin of allowance for contingencies related to the business’s capital assets, inasmuch as possible costs of major repairs are adequately provided as depreciation and amortization valuations.

To illustrate, let us compare an EBIT of $72,000 vs. an EBITDA of $94,200. Dividing these two figures for 12 months will result in quotients of $6,000 and $7,850, respectively. These figures represent estimated monthly income that is free to use. If the loan applied for will bind the borrower to pay a monthly amortization of $3,800 per month, the estimated monthly earnings for both concepts could adequately cover the additional loan payment expenses.

However, lenders would prefer a more conservative stance by choosing the EBIT of $6,000 as projected unencumbered funds. Cost of future major repairs will not affect the remaining projected usable funds since depreciation and amortization expenses were already projected as part of operating expenses.

This is quite the opposite of the $7,850 monthly EBITDA, in which major repairs are still liable to eat up the usable funds generated by the business. Under this concept, eliminating depreciation and amortization charges works under the scenario that the company’s major assets will not undergo any breakdowns or repairs during the term of the loan.

Which Measure Tends to Create a “False Sense of Security”?

The principle of materiality is likewise disregarded, because depreciation and amortization charges have significant impacts on the actual condition of the company’s assets. As an example, assuming that a company owns fixed assets amounting to $500,000, which were all purchased on the same date. The entire lot will have total annual depreciations of $100,000.

Since the depreciation amount is considered as material, EBITDA will distort the profitability of the company by adjusting the performance ability of the company with a material amount. This will likely create a “false sense of security” to both borrower and lender.

Which Concept Allows the Attainment of Objectives?

In EBITDA, the concept loses the principle of objectivity as the aim of projecting the estimated free money is to determine the degree of credit risk. In projecting a higher income, credit risk is diminished but the precariousness of capital assets in their use as tools for generating income is excluded from considerations. Hence the risk is still present but has not been defined as part of the risk established during the process of evaluation and decision making.

Although EBIT is commonly preferred by lenders, EBITDA works out a compromise for high-risk lending. Since it produces higher projections of available funds, this premise works favorably for the viability of a company as borrower. The concept likewise provides a corresponding leverage in favor of the lender to give lesser loan value to the assets offered as collateral.

This way, the degree of risk the lender will undertake will be compensated by greater returns in case of asset foreclosures. Borrowers, on the other hand, will work doubly hard to meet their obligations rather than part with their assets at relatively little or no gain at all.

These are the essential differences to consider, whether to choose between EBIT vs. EBITDA in determining credit risks.

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