A way to exclude the oranges.
© Everyday better to do everything you love—iStock/Getty Images; Photo illustration Encyclopædia Britannica, Inc.
When it comes to a company’s financial statements, net income, earnings per share (EPS), and revenue are the numbers that grab the headlines. But when analysts are doing a deeper dive to examine a company’s profitability and potential for future growth, they calculate other values from the income statement, such as earnings before interest and taxes (EBIT) and earnings before interest, taxes, depreciation, and amortization (EBITDA).
The headline earnings numbers are important scorekeeping devices, but it’s the sliced-and-diced numbers such as EBIT and EBITDA that can help you understand where a company is making its money, whether its profits might be sustainable, and how those profit numbers compare with other companies in the same sector and industry.
Key Points
- Earnings before interest and taxes (EBIT) is calculated by removing interest income, interest expense, and taxes from net income.
- By adding back non-cash expenses such as depreciation and amortization, EBIT becomes EBITDA: earnings before interest, taxes, depreciation, and amortization.
- Examining EBIT and EBITDA allows investors to analyze profit solely from a company’s normal business activities.
The income statement is a useful way to see how a company makes money and how it spends it. You can look at an income statement for just one day or covering a month, a quarter, a year, or several years. The income statement is sometimes called a P&L because it shows a company’s profit and loss:
Revenue – expenses="profit" (if the number is positive) or loss (if the number is negative)
An income statement has a typical structure, no matter what the type of business. Companies can use the income statement to see not only their net profit, but also where and how money is made and lost.
Revenue. Revenue is another name for income; it’s money that comes into a business from selling goods or services. Revenue is reduced by any discounts or refunds given, as well as by returns, to calculate net sales.
Cost of goods sold. Some businesses break out expenses specifically related to their sales, such as labor, parts, or materials used to make a product. That’s so they can see how the revenue from their sales compares against the expenses directly required to generate that revenue:
Gross profit="revenue" – cost of goods sold
General and administrative (G&A) expenses. G&A includes all the rest of the expenses needed to run a business:
Operating income="gross" profit – general and administrative expenses
Earnings before interest and taxes (EBIT)
Operating income shows the net revenue earned from a business’s normal operations. For some businesses, there may be other other income and expenses that are deducted from operating income to reach the final net income or loss. These might include:
- Gains and losses from investments or foreign transactions.
- Expenses such as research and development, sale of equipment, or other industry-specific items.
- Interest income earned on investments.
- Interest expense paid to lenders.
- Taxes paid on business revenue
When calculating earnings before interest and taxes (EBIT), operating income is adjusted to reflect all other income and expenses except interest and taxes.
EBIT="operating" income – other income and expenses except interest and taxes
Do all businesses show taxes on their income statements?
Only corporations are taxed as separate entities by the IRS, so only corporations show federal taxes as an expense on their income statements. In contrast, sole proprietorships, partnerships, LLCs, and S corps are all taxed via the personal tax returns of their owners. State taxes are sometimes reflected on an income statement, no matter what the ownership structure. Learn more about the differences between business structure types.
Earnings before interest, taxes, depreciation, and amortization (EBITDA)
Non-cash expenses on the income statement, such as depreciation and amortization, are added back to EBIT in order to calculate earnings before interest, taxes, depreciation, and amortization (EBITDA):
EBITDA="EBIT" + depreciation and amortization
- Depreciation. Fixed assets such as equipment and buildings lose value as they age. Although no cash is spent, companies will calculate this incremental loss as depreciation, which will slowly reduce the book value of the asset on the balance sheet and will also be recorded as an expense on the income statement.
- Amortization. If a company has intangible assets, such as patents, goodwill, or copyrights, any reduction in value will be recorded as amortization.
Why would you look at EBIT or EBITDA?
Removing certain variables when looking at profit can help you better compare different companies’ financial statements. EBIT and EBITDA remove select income and expense items, plus the effect from some of the assets and liabilities on a company’s balance sheet, so you can focus on income from only its actual business:
- Investments on a company’s balance sheet earn interest income.
- Debt on a company’s balance sheet results in interest expense.
- Taxes can vary based on the tax structure and tax rates.
- Fixed assets such as buildings and equipment result in depreciation expense, unless they are fully depreciated.
- Goodwill, patents, and copyrights result in amortization expense, unless they are fully amortized.
A company that’s been in business for many years may have more investments and fully depreciated equipment, whereas a new business may have debt and depreciation expense. By comparing the EBIT and EBITDA of these companies, you should be able to see income generated solely from their operations over a period of time.
Net income: profit or loss
Net income is the final number on the income statement (P&L); it flows into retained earnings on the balance sheet. All income and expenses, including interest and taxes, are used to calculate net income.
Net income="EBIT" – interest expenses + interest income – taxes
A company’s income statement shows how it makes and spends money over a period of time. Compare several years of a company’s income statement to highlight trends. Look at EBIT and EBITDA as well as net profit to get a fuller picture of a company’s activities, especially when comparing them to other companies in its industry.
Publicly held companies are required to file quarterly reports with the Securities and Exchange Commission (SEC). You can access these reports through a company’s investor relations section on its website, or via the SEC EDGAR database. You can also listen to the company’s quarterly earnings calls to hear company executives’ views of current business conditions.
Following company financials is important, not only before you invest, but also on an ongoing basis. If something changes and an investment no longer fits your objectives and risk tolerance, it might be time to move on.
This article was most recently revised and updated by Nancy AshburnThis article was most recently revised and updated by Jennifer Agee
