In the coming months, I’ll be writing a series of articles explaining common terms and acronyms that get thrown around by professional investors. I'll try to keep the language straightforward, and I hope I can shed light on some of these terms. For the first entry, I’ll be explaining one of the most important and common acronyms – EBIT.
Alternative phrases: Operating earnings, operating profit.
Short explanation: EBIT stands for Earnings Before Interest and Tax. As the name implies, it’s calculated by subtracting net interest expense and taxes from earnings. ‘Earnings’ in this context means NPAT minus significant items, such as non-cash write-downs.
More detail: The obvious question when first encountering EBIT is ‘why would someone want to subtract real expenses, like interest and tax?’ There are a range of reasons for this, but I’ll cover some of the key ones.
When calculating certain ratios, it’s important to exclude financing costs from the equation. For example, when calculating interest coverage. Interest coverage tells you how easily a company is able to service its interest costs on its debt. As you’re calculating the amount of money available to pay interest, it would create double-counting to deduct interest payments from this figure. As tax is calculated based on profit before tax (i.e. interest expenses are tax deductible), it is always deducted after interest expenses.
Where a whole business is being purchased, EBITDA*, a variation of EBIT, is sometimes used. However, if a company has high sustaining capital requirements (for example, an operating gold mine) it might be inappropriate to instead use EBIT. Interest and tax are excluded as any debt may not be taken on by the purchaser, and the tax rates may differ.
The EBIT metric may not be particularly useful for banks and other businesses that make a significant portion of their income from interest revenue.
*The ‘DA’ in EBITDA stands for Depreciation and Amortisation. These concepts will be explained in a later blog.
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