EBIT vs. EBITDA: Differences in Calculations

In the world of mergers and acquisitions, global financial institutions are constantly searching for companies to acquire and sell. Many of us see offers of exorbitant amounts of money for one well-known company to purchase another well-known company. The question then arises in our minds, how exactly are they coming up with these figures?

In many cases, they are using EBIT or EBIDTA to measure both the current value of the company, as well as its underlying financial health. These are both based on generally accepted accounting principles.

EBIT and EBITDA are two ways of more accurately measuring a company by taking into account things like tax jurisdiction, expenses, debt repayments, and asset depreciation. They are effectively taking a “deep dive” into the value and health of a company, regardless of its location and industry.

What is EBIT?

EBIT stands for “earnings before interest and taxes.” This measurement determines the earnings of a company while taking into account debt, interest, and taxes and is considered to be extremely important when measuring cash flow. Some businesses think of EBIT as a company’s operating profit.

How to calculate EBIT

There are two main ways of calculating EBIT, both of which can be calculated using the information on an income statement. In the first calculation, you measure the company’s net income after they have paid absolutely all of their outgoing costs. You then add back the expenses, if any, for both taxes and interest payments.

The second way to calculate EBIT is to measure the company’s total revenue, subtract the cost of goods sold, and subtract the operating expenses. In this model, the operating expenses will typically include the cost of both debt interest and taxes paid in the relevant jurisdiction.

EBIT calculation example

Let’s see this in practice. Below you can see some financial information for Smallz Burger Joint, a modest corner business. For the purposes of this example, we’ll use the first equation mentioned earlier.

Based on the cash flow analysis, Smallz Burger Joint collects $100,000 a year after they pay for all of their outgoing costs. This includes the costs of the burgers and other food, paying employees’ salary and benefits, and the rent of the restaurant space.

From an investor’s perspective, the tax and debt are almost beside the point. This is because debt can be refinanced with a different capital structure, and taxes can change in a different jurisdiction. In this way, the operating profit of a company can be looked at through the lens of a more comprehensive financial snapshot.

Unfortunately, not all financial snapshots reveal good news. If your business needs a little help, you may want to consider a business loan. Before signing the dotted line, be sure to compare lenders and get the best use out of these additional funds.

What is EBITDA?

EBITDA stands for “earnings before interest, taxes, depreciation, and amortization.” Similar to EBIT, EBITDA is used to calculate a company’s financial health. However, unlike EBIT, it also takes into account depreciation and amortization. Depreciation and amortization are ways of calculating the cost of an asset over its lifespan.

Although in its day-to-day operations depreciation and amortization do not really affect a company’s operating cash flow, it’s important when looking at industries that are asset-heavy.

What is depreciation?

Depreciation is typically related to fixed, tangible assets. If it’s something that you can touch, chances are it will depreciate.

Depreciation is usually calculated by subtracting the salvage value of an asset and subtracting it from the value it was originally acquired for. You then spread that out through a number of years until you can reach an annual assumed depreciation amount.

Examples of this type of asset can be a warehouse where you store goods for your business or the complex machinery that you invest in at the launch of a manufacturing business.

What is amortization?

Amortization calculates the cost of maintaining an intangible asset. This calculation is especially helpful for assets that don’t have any salvage or resale value. Instead, it’s an asset that will lose value over a period of time until the end of its lifespan.

Examples of this type of asset can be a patent or license that you maintain for a business. For example, suppose you are a telecom company licensing a tower for your 5G service, or you are a pharmaceutical company with a patent for a new drug. In that case, you can view the amortization expenses to determine the cost to maintain this asset.

How to calculate EBITDA

Like EBIT, there are two mainstream ways of calculating EBITDA. In the first equation, we look at the net income of the business after all of the outgoing expenses are paid. We then add back the taxes and interest expenses as we did with EBIT.

However, in this scenario, we also add back the depreciation and amortization as well. This is often done to calculate the cost of both a business’s tangible and intangible assets.

In the second equation, we only consider the business’s operating income instead of its net income. Rather than subtracting all expenses from a company’s gross profit, a business’s operating income comes from deducting operating expenses only.

EBITDA calculation example

Let’s say that Smallz Burger Joint didn’t work out the way the owner wanted it to. Luckily, the owner had an idea to start a new business in a completely different industry. However, this business is a manufacturing plant creating components used in the fabrication process for semiconductors. This means the new business is a lot more investment intensive.

Here you can see how the EBITDA calculation and business structure differ. Smallz Burger Joint did not have that much capital outlay for equipment, and the owner was simply renting the building. However, when the owner started the semiconductor component business, they needed to buy a facility and all the equipment to make the components upfront, which are tangible assets.

When calculating EBITDA, you also account for any tangible assets, such as the building and the equipment.

EBIT Vs. EBITDA: Which one is better?

Unfortunately, there isn’t a straightforward answer to that question. One measure is not inherently superior to the other. EBIT and EBITDA are both helpful when understanding the financial health and investment profile of a company. That being said, EBITDA is considered to be more of a deep dive into a business’s financial health, rather than just a cash flow statement.

One way this can be explained is the difference between an internet company and a manufacturing company. Typically, a company that is based on the internet doesn’t need to buy a lot of assets to get started. The upfront costs for an internet company are minimal, usually computers, server space, rent, and support staff.

However, manufacturing companies may require investments in both pieces of equipment and the building you are manufacturing in. Therefore, a manufacturing company might use a tremendous amount of its cash flow upfront to cover the expense of these assets. But the assets are still worth something and thus are incorporated when calculating EBITDA.

Why would you use EBIT instead of EBITDA?

You would use EBIT when measuring a company’s value that possesses few investments or assets, like Smallz Burger Joint. If the business had several investments, such as Smallz semiconductor components business, you would use EBITDA.

Revenue vs. EBIT vs. EBITDA

Revenue, EBIT, and EBIDTA are three terms you should understand when attempting to measure a company’s health.

Revenue is the amount of money a company brings in selling its goods and services. EBIT and EBITDA take into account things like operating expenses, taxes, depreciation, and amortization.

Here you can see that it’s important to measure everything when evaluating and measuring a business. Although revenue is an easy first look, one must delve inside the inner workings of a company to assess its true financial health and value.