Increasing interest expense will have what effect on earnings before interest and taxes (ebit)?

Earnings before interest and taxes, more commonly referred to as EBIT, is a standard accounting term identifying a business’s operational performance. EBIT defines a business’s net income and does not include its income tax or interest expenses.

Learn about EBIT, how accountants calculate it, and why businesses often prefer to use it to share their performance with creditors and investors.

EBIT is an acronym for earnings before interest and taxes. Accountants use EBIT to identify a business’s net income before deducting expenses such as income tax and interest. EBIT is a non-GAAP measure—meaning it is not a traditional accounting principle. It is used to share a company’s operational earnings and ability to generate a profit. 

EBIT can be used in two ways. First, it is used within a company by decision-makers who want to evaluate its operational performance and profit. EBIT is also used by investors who want to understand a company’s profit.

When evaluating a company’s EBIT, compare the current year’s income with previous years’. The current revenue and EBIT will help identify trends in a business’s profitability.

• Alternate names: Operating earnings, profit before interest and taxes 
• Acronym: EBIT

There are two formulas for calculating EBIT. The first is considered a direct definition of EBIT because revenue is adjusted with all related expenses. It looks as follows:

Earnings - Cost of Goods Sold - Operating Expenses ＝ EBIT

The second formula is considered indirect because it shows us what needs to be added to the net income. It’s calculated this way:

EBIT = Net Income + Income Tax + Interest Expense

Although both equations will end with the same net income, the formulas are used for different reasons. The first is used to measure operational performance, while the second is analyzing profitability.

Let’s explore an example of both EBIT formulas in action. Beautopia is a company that manufactures wigs, which are later sold in retail spaces. This year, its income statement shows the following:

• Earnings: $1,000,000
• Cost of Goods Sold: $600,000
• Gross Profit: $400,000
• Operating Expenses: $100,000
• Interest Expense: $50,000
• Income Tax: $50,000
• Net Income: $200,000

Using both formulas, Beautopia’s EBIT comes to $300,000.

EBIT is categorized as non-GAAP earnings, meaning it is not recognized as a generally accepted accounting principle. Non-GAAP is considered an alternative to traditional accounting methods as it measures a company’s earnings. A company’s EBIT is performed at the end of the fiscal year using data included in its income statements.

It is essential to understand the industry standard when setting an EBIT benchmark. Comparing the operating profits of other companies within your industry will provide a robust analysis that can help guide you in setting your own business's EBIT benchmark.

The purpose of EBIT is twofold. Businesses often use EBIT internally to make decisions related to the operation and management of their company. By evaluating earnings, cost of goods sold, and expenses, a company can identify how to save and make more money within their business.

Investors also use a company’s EBIT to understand that company’s profit. By analyzing operating earnings instead of net income, investors can realize profitability without considering the interest expense or income tax. Investors analyze the EBIT metrics of various companies within an industry when they want to understand operational profit and performance. The EBIT metrics can help them decide whether or not to invest in a company.

For instance, say an investor is interested in two companies that manufacture wigs. They will need to look at the gross profit, net income, and operating expenses of each to understand the businesses’ true profitability.

Finally, EBIT is included in various financial ratios developed by companies. These calculations have an interest coverage ratio as well as an operating profit margin.

• EBIT is the acronym for earnings before interest and taxes. It is a business’s net income and does not include deductions such as income tax and interest expenses.
• The purpose of EBIT is to analyze a company’s performance based on its operations so that investors can have an understanding of its profitability.
• Company decision-makers can also use EBIT internally to gain a clear understanding of a business’s operational performance and profit.
• EBIT is also referred to as operating earnings or profit before interest and taxes.

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 taxes and capital structure, such as interest and tax expenses. Often EBIT will not equal the operating profit. This is due to the company incurring expenses that are not part of their recurring operations. Therefore they will be added back to complete the EBIT calculation.

EBIT Formula

EBIT = Operating Profit + Non-recurring + Non-core + Non-controlled

This formula assumes that items which reduce reported operating profit are positive and items which increased the operating profit are negative. It is imperative that +/- signs are correct so you don’t accidentally add an item twice!

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.

• EBIT is the abbreviation for earnings before interest and taxes and is a calculated number which shows a company’s recurring profit from its operations
• For some companies, EBIT is equal to their operating profit
• If operating profit is not reported, it can be calculated starting from revenues or net income
• EBIT is a popular performance tool to aid comparisons between similar companies
• The metric helps understand the recurring profit generated from operations which is useful for forecasting data

Further Steps Needed to Calculate EBIT

How is EBIT Calculated?

EBIT is calculated by subtracting a company’s cost of goods sold (COGS) and its operating expenses from its revenue. EBIT can also be calculated as operating revenue and non-operating income, less operating expenses.

As mentioned at the beginning, sometimes the operating profit of a company needs adjustments to arrive at 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). Below is the order of steps you should complete to arrive at the EBIT figure:

• Start at operating profit in the income statement (if not reported then calculate starting at revenues or net income)
• Check above operating profit for any reported items which should not be included
• Check below operating profit for any reported items which need to be added back
• Check MD&A and financial footnotes for more detail and embedded non-recurring items. Use the lines above operating profit to guide your search, and use lines below operating profit as those you can safely ignore

EBIT Calculation

Use the following income statement and footnotes to calculate EBIT.

The calculation starts at profit before interest and tax (operating profit) and adds back the legal claim provision included in SG&A (non-recurring item).

Bonus: To calculate EBITDA, you would need to add back the depreciation and amortization expense in cell C20.

Make sure to download the worksheet to try a bonus workout with a full solution provided.

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? are 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 metric when comparing different companies.