Earnings before interest and taxes (EBIT) is probably the best known of the selective earnings metrics that analysts and financial specialists use to evaluate earnings performance. As the name suggests, EBIT measures earnings as Income Statement revenues less all expenses—except for interest and tax expenses.
This article explains why analysts sometimes turn to EBIT and other selective metrics, in place of "bottom line" Net Income. The article also defines and compares five of the best known selective income metrics.
The Family of Selective Income Metrics.
EBIT belongs to a family of metrics called Selective Earnings or Focused Income metrics. The term "selective" means these metrics derive from a just a few selected items on the Income statement. They do not reflect all revenues and expenses. Their names begin with "Earnings before...," and then a list of excluded items. As a result, they are also known as Earnings Before metrics.
Selective Income metrics address questions like these:
- Is the company earning acceptable profits in its core line of business?
- Did the firm reach its objectives for earnings growth?
- How do company earnings compare to competitors?
Analysts address such questions by comparing earnings from the firm's latest Income statement to:
- Earlier Income statements.
- Competitors earnings.
- Industry averages and best-in-class standards.
Why Use Selective Income Metrics?
The first metric that comes to mind at the mention of earnings is Net Income, the Income Statement "bottom line." Net Income, however, can be less than helpful for certain earnings questions. Net Income can be misleading when:
- The primary interest is income from the core line of business.
- There are large expenses for items such as depreciation, interest, or taxes.
As a result, corporate officers and shareholders sometimes turn instead to selective income metrics such as EBIT, for a clearer view of core line of business earnings.
The article further explains the purpose and use of selective earnings metrics. Sections below define, explain, calculate six popular earnings metrics:
- Net Income.
- Operating Income.
- What are earnings before interest and taxes EBIT? And, what are selective income metrics?
- What is the purpose of selective income metrics? Where are they used?
- Explain the most popular "Earnings before" metrics? How do they compare to Net Profit?
- Defining and calculating operating income (operating profit, earnings from operations).
- Calculating and explaining earnings before taxes (EBT, pre-tax earnings, profit before tax, PBT).
- Defining and explaining earnings before interest and taxes (EBIT).
- Explaining and calculating earnings before interest, taxes, depreciation & amortization (EBITDA, operational cash flow) .
- Defining and calculating earnings before extraordinary items, interest, taxes, depreciation, and amortization (EBEITDA).
- Example Income statement for earnings metrics.
Net Income by itself is not always the most helpful metric for evaluating earnings. Potential problems with Net Income have to do with some of its revenue and expense components.
Remember that reported Net Income is simply an instance of the income equation:
Income = Revenues – Expenses
In reality, Revenues and Expenses can mean quite a few individual items. For Net Income, these include normal operating expenses, of course. And, they also include expenses outside the firm's normal business. Expenses for Net Income may also reflect accounting conventions, taxes, and unusual losses. When present, these can "muddy the waters." They can, that is, distort the meaning of Net Income—at least for the firm's core line of business.
Consider, for example, how Domino's Pizza LLC presents earnings in annual reports. When discussing earnings, Domino's officers highlight EBITDA instead of Net Income. (EBITDA represents earnings before interest, taxes, depreciation and amortization). Some shareholders no doubt ask: "Why focus on EBITDA?"
Why Focus on EBITDA Instead of Net Profit?
Domino's business operates in the highly competitive "quick service restaurant" industry. For several years the company has pursued market and growth goals by adjusting its competitive strategy. As a result, management needs accurate feedback on how these changes impact earnings in their core line of business. In particular, they need earnings metrics that are precise. Precision is crucial, because period-to-period changes of just a few percentage points can signal success or failure with strategic changes. This is important for officers, investors, competitors, and everyone else with a keen interest in the firm's prospects for growth.
Domino's, however, has asset holdings, worldwide, which create large depreciation expenses from year to year. In addition, the company and its franchise owners finance operations and acquisitions differently in different countries. Also, Domino's operates in many different tax jurisdictions. All of this means that taxes, interest, and depreciation impact Net Income differently in different regions and countries. Domino's therefore looks to EBITDA instead of Net Income for a clearer, truer measure of earnings.
Bottom Line Net Income Still Matters.
All of the reasons for using selective metrics aside, however, it is still bottom line Net Income that determines a firm's legal responsibilities. Every year, for instance, companies must calculate and pay taxes. Directors must declare dividends and retained earnings. These actions deal with Net Income, not EBITDA.
Selective Income metrics are built from Income statement figures. In fact, those familiar with the Income Statement should find that the names of individual metrics define themselves.
The table below lists and compares popular income metrics on the basis of their contents.
GAAP-defined metrics vs. non-standardized metrics
When comparing earnings metrics across companies, remember that some definitions leave room for analyst judgment or preference. Some selective income metrics, that is, allow analysts to decide, partially, what the metric represents.
- GAAP-defined metrics below offer the least flexibility of this kind.
- Non-standardized metrics offer more flexibility.
"Earnings before" metrics, therefore, should always be annotated stating what the metrics include and what they do not include.
Selective Income Metrics
|INCOME METRIC INCLUDES...|
|Operating Rev & Exp||Tax Impacts||Deprec|
|Non Interest Financial income|
|Non Op Income & Exp Including Ext Items|
|Net Income |
|Operating Income |
|Yes||No||Yes||No||In some cases |
|Earnings Before Taxes (EBT) |
GAAP Defined 2
|Earnings Before Interest and Taxes (EBIT) |
|Yes||No||Yes||No||Varies by user preference ||Varies by user preference |
|Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) |
|Yes||No||No||No||Varies by user preference ||Varies by user preference |
|Earnings Before Extraordinary Items, Interest, Taxes, Depreciation, and Amortization (EBEITDA) |
|Yes||No||No||No||Varies by user preference ||No|
1. Revenues from interest earnings may be appear in Operating income only if they represent the firm's normal business.
2. Earnings before taxes (EBT) results directly from GAAP-specified Income statement items. EBT is therefore "GAAP Defined."
3. The Non standardized Income metrics, EBIT, EBITDA, and EBEITDA, are defined differently by different analysts. Some choose to include financial revenues and extraordinary items in these metrics, for instance, while others choose to exclude such items.
Operating income, or Operating profit, or Earnings from operations represents company earnings from its core business. This metric shows the firm's earnings before adding revenues and expenses for extraordinary items, and before financial earnings or expenses (if the firm is not in financial services).
Operating Income is a GAAP-Defined Metric.
Operating income appears on the Income statement, in currency units. It is often discussed, however, as operating margin, that is, as a percentage of Net sales revenues. Either way—as a margin or in currency units—operating income is appropriate for comparisons to competitors or to industry standards.
Operating Income and Net Income Sometimes Send Opposite Messages
It is possible to report a positive Operating income and negative Net Income for the same period. This typically occurs in periods with large unusual expenses due to workforce reductions, natural disasters, or legal judgments. This can also occur when a firm declares investment losses or very large financial expenses (for companies not in a financial industry).
When Operating income and Net Income differ like this, expect the officers to emphasize Operating income in the Annual Report. They do this to show that the company is performing well in its core line of business. They may also point to Operating income and argue that future prospects are good, in spite of current losses.
Of course companies sometimes report the reverse—positive Net Income along with negative Operating income. Here, overall profitability is "rescued" by extraordinary income or financial income. This may come from the sale of real estate, other assets, or investment securities, for instance. Even though net profit is positive, however, the situation calls for serious concern. Directors, officers, and shareholders will want to know exactly why the core line of business is not performing well. And, they will want to know just how leaders intend to improve prospects for the future.
Calculating Operating Income.
Operating income before taxes normally appears directly on the Income statement. The income equation defines Operating income as follows:
Operating Income = Net sales revenues
–Cost of goods sold (or Cost of sales, Cost of services)
– Operating expenses
In the example below, Grande Corporation reports:
Operating income before taxes: $3,130,000.
Operating income after taxes on operating income: $2,172,000
Net Income after taxes: $2,126,000
Income Statement for Operating Income Input Data
Operating Income: Pretax or After Tax Basis?
Operating income discussions usually refer to pre-tax Operating income. This is because pre-tax operating income normally appears directly on the Income statement, while after tax operating income does not.
The analyst who wants to find after tax operating income starts with the pre-tax income figure and then takes two steps.
- Firstly, calculate the tax liability specifically for the pre-tax income figure.
- Secondly, subtract that tax figure from the pre-tax income figure.
The bottom three lines of the above statement show how that is done. Note from the above calculations that the income tax is Tax on operational income only. This is not the normal Income statement line Income tax on operations. The two can differ because the latter may include—as it does here—tax impacts of financial revenues and expenses.
Here, to find the tax on "operational income only," the analyst multiplies the marginal tax rate on operating income (here, 35%) by the before tax operating income figure. Here, that is
Tax on operating income only = 35.0% * $3,130 = $1,096
Earnings before taxes EBT, or Pre-tax income, or Profit before taxes PBT shows company earnings before paying taxes. Pre-tax income is useful for comparing earnings of companies in different tax jurisdictions.
A similar comparison occurs, for instance, when considering the salaries of individuals: two employees may have identical gross salaries but different after-tax income because they pay income taxes at different rates. Pre-tax salary figures show, however, that the employer pays both employees the same salary. Similarly, the pre-tax earnings metric is a more direct comparison of earnings between companies in different tax jurisdictions.
Using the Income statement equation, Pre-tax earnings are simply:
Pre-tax Income = Revenues – Expenses (except tax expenses)
In reality, the simplest way to calculate Pre-tax income from Income Statement data is to start with after tax Net Income, and then add back all taxes that were subtracted earlier. For example:
All Figures in the EBT example above are GAAP defined. Therefore, EBT is GAAP-defined.
Earnings before interest and Taxes EBIT is another pre-tax income metric, slightly more selective than EBT(above). As its name says, EBIT represents earnings before considering tax and interest expenses.
- EBIT and EBITDA (next section) are popular with investment analysts, who must compare earnings from companies with different capital structures.
- Companies with a high leverage capital structure have greater interest expenses than companies with lower leverage. (High leverage means that lenders account for relatively more of the firm's funding than owners.)
EBIT measures income before interest expenses are factored in. Therefore, EBIT provides a more accurate comparison of earning between companies at different leverage levels.
And, as with EBT, EBIT is also useful for comparing earnings of companies from different tax jurisdictions.
Important Characteristics of EBIT
Several important characteristics of EBIT are as follows:
- EBIT is the same as Pre-tax net income, except that EBIT also excludes the contributions of interest expenses paid.
- EBIT is usually presented as Pre-tax income from operations as well as all non operational income and expense (except for interest paid). When presented this way, EBIT reflects extraordinary gains and extraordinary costs as well as depreciation and amortization.
- For companies not in a financial industry, EBIT excludes the impact of interest paid.
- EBIT is not GAAP-defined, and reports of EBIT may or may not include financial income and non-interest expenses.
From the income equation, EBIT is defined as follows:
EBIT = Revenues – Expenses (Except Tax Expenses and Interest Expenses)
When reporting non-standard metrics like EBIT, it is always good practice to state clearly what the metric includes. EBIT, for instance, should appear along with a note stating whether or not the metric includes financial or other non operating revenue.
In practice, EBIT is easier to calculate by starting with Net Income and adding back interest and taxes.
Earnings before interest, taxes, and depreciation and amortization EBITDA, or Operational cash flow, is another pre-tax income metric, still more selective than EBIT . As the name suggests, EBITDA represents earnings before taxes, interest, depreciation, and amortization.
EBITDA, like EBIT, excludes interest and tax expenses. As a result, EBITDA also is useful for comparing earnings under these conditions:
- The companies have different capital structures. This means they have different levels of interest obligations.
- The companies operate in different tax jurisdictions are therefore taxed at different rates.
EBITDA excludes everything that EBIT excludes, but EBITDA goes further to also exclude depreciation have amortization. These expenses can be large, and they can very considerably between companies or even from year to year within one company.
These expenses, moreover, are non cash expenses. This means they are not real cash flow but they do lower Net Income. As such, they further distort the earnings picture from overall Net Income. By excluding depreciation and amortization expenses, EBITDA is immune to such distortions.
Important Characteristics of EBITDA
Note especially the following about EBITDA:
- EBITDA is sometimes called Operational cash flow. This is because it excludes depreciation and amortization (non cash flow expenses),
- GAAP does not define EBITDA . It is thus a non standardized metric.
- Some analysts choose to include only operating revenues and expenses in the metric. Those analysts claim that EBITDA and Operating income are the same thing. They may even use the two terms interchangeably.
- Others believe the definition should include financial revenues and expenses (other than interest expenses), as well as non operating expenses including extraordinary gains and losses.
- Equating EBITDA and Operating income is a risky, at best, because GAAP includes depreciation in operating income, whereas EBITDA by definition does not.
- Those who allow financial and non-operating revenues and expenses into EBITDA obviously do not see operating income and EBITDA as the same thing.
Using the Income statement equation, EBITDA represents:
EBITDA = Revenues
– Expenses (except expenses for taxes, interest,
depreciation, and amortization)
Example Calculating EBITDA
In practice, EBITDA is easier to calculate by starting with Net Income and adding back interest, taxes, depreciation, and amortization expenses. The following example uses data from the example statement below.
Grande Corporation EBITDA for the year calculates as:
Here, EBITDA ($4,372,000) exceeds Operating income ($3,130,000). Thus, operating EBITDA are not always the same. Here, they differ for two reasons:
- Operating income reflects depreciation expense, while EBITDA does not.
- Also, the analyst chose to include non operating revenues and expenses in EBITDA , whereas they are normally excluded from operating income.
Earnings before extraordinary items, interest, taxes, depreciation, and amortization or EBEITDA is clearly the most selective of the income metrics described here.
EBITDA is Not Standardized by GAAP
Note especially that EBEITDA is another "earnings before" metric not standardized by GAAP. As with other non-standardized metrics, simply naming the metric does not fully specify what it represents.
When is EBEITDA Just Another Instance of EBITDA?
To some, EBEITDA seems like another instance of the slightly less selective metric, EBITDA. That view is possible because EBEITDA and EBITDA differ on only two minor points.
- Firstly, the analyst may choose whether or not to include extraordinary items in EBITDA.
- Secondly, EBEITDA by definition excludes extraordinary items.
EBEITDA and EBITDA are therefore the same when EBITDA excludes extraordinary items.
Otherwise, EBEITDA serves a unique role in its own right. EBEITIDA and EBITDA are different metrics when both of these conditions apply:
- An EBITDA metric is also in view.
- The EBITDA metric includes large extraordinary items.
In such cases, analysts see EBEITDA (rather than EBITDA) as the truer measure of earnings in the core line of business. This is because EBEITDA explicitly excludes extraordinary items.
Example Income statement for Earnings Metrics.
Examples Above Use Data From the Sample Income Statement Below.
This statement represents a manufacturing firm. However, the structure and contents are similar across a wide range of industries.