By far, one of the most important tax-related items that businesses just aren't paying enough attention to can be summed up in a single acronym: EBIT.
Also commonly referred to as "Earnings Before Interest and Taxes," EBIT is a metric that shows a company's earnings before things like interest and tax expenses get added to operating costs.
Many people assume that EBIT and net income are essentially the same things - this would be a mistake. EBIT specifically excludes both interest expenses and income taxes from the calculation that you would use to arrive at your net income.
If calculated correctly, and if an organization can make a profit, net income will actually be less than EBIT. This is because net income includes far more expenses than EBIT does.
If all of this sounds a bit complicated, that's because it admittedly is. But to make the most out of this helpful metric, you'll want to keep a few key things in mind.
What You Need to Know About EBIT: Breaking Things DownWhen calculating EBIT, it's important to note that there are actually a few different formulas that you can choose from depending on your needs.
The first involves taking your total revenue, subtracting the cost of any goods that have been sold, and further subtracting your operating expenses. Keep in mind that here, revenue is defined as both sales and any other transactions that generate cash for your business. This could include any gains on the sale of an asset, for example.
The cost of goods sold will include not only the raw materials that were necessary to make those items but also labor costs that are directly related to the process as well.
Operating expenses would include any costs that are not specifically related to the product, but that are necessary anyway. Rent (or a mortgage) on your operating space would be a prime example of this.
Finally, interest payments - and the income tax expenses that you're likely dealing with - would also be a part of this process.
Next, we have a second version of EBIT that may be applicable depending on the scenario. Here, you'll be taking your net income and adding to it both your interest expenses and your tax expenses.
Much like the first version, the calculation itself begins with net income. However, this version of the calculation adds back in those expenses to paint a clear picture of exactly what is going on with your organization. If done properly, you should arrive at the same dollar amount with both versions of the calculation, regardless of which one you pick.
All told, EBIT is important because it allows business leaders to better analyze their company's performance based on day-to-day factors that matter a great deal. This includes business operations in a way that also disregards debt and tax rates.
Many companies also use EBIT to compare themselves to their competitors to see how they're doing in the marketplace.
The Relationship Between EBIT and Your DebtAnother one of the most critical things to understand about this entire process ultimately has to do with the relationship between your EBIT calculation and the debt you've taken on to this point.
Remember that any business' capital structure will always make a large impression on the amount of debt they carry. Interest expenses - a part of the EBIT calculation - only serve to expand upon that debt.
Needless to say, all organizations need capital to keep operating. Companies raise capital in a wide range of different ways, including by issuing stock or even borrowing money from lenders. In this context, the term "capital structure" refers to the percentage of money being raised for daily operations that comes from activities like issuing stock or taking out loans.
All of this will directly impact your EBIT calculation. The same is true of the amount of assets that are needed for an organization to operate successfully. This is something that will vary depending on the industry that you're operating in. Something like a bank or other financial institution, for example, needs to raise a significant amount of capital upfront - not just to invest in the technology that they need to serve their customers, but to hire employees and operate physical locations as well. Something like a manufacturing company will need to raise capital in order to buy the machines that they need to produce their goods. All of these costs add up and they all have an impact on EBIT.
The Nexus Between EBIT and Taxes
The same is true of the relationship between EBIT and taxes, albeit from a slightly different perspective.
For the sake of example, say that two businesses operate in the same industry and enjoy very similar profits. Despite this, they can both be dealing with very different levels of tax expenses depending on the context.
The United States tax code is nothing if not complicated. There are a host of different factors that can and likely will impact the tax expenses that an organization is expected to pay.
This is especially true if you do something like a tax carryforward, for example. This is a technique that allows a business to reduce the amount of money they owe this year by counting losses that have occurred in the past. This will absolutely lower the tax expenses of the current year and because of that, the current year's EBIT will be lower.
In the end, the EBIT calculation has a wide range of valuable uses. It's a great way to confirm your organization's net income in an income statement, for example. It can also help make sense of both tax expenses and interest expenses in the said income statement.
Many organizations use EBIT to compare their own performance to those of industry benchmarks to make sure that they're hitting their goals.
Regardless, provided that you're aware of the full potential of the EBIT calculation, you'll be able to enjoy all of the benefits and insight it brings with it.
About Sonu Shukla, CPA, CFP
Sonu Shukla is a Certified Public Accountant as well as Certified Financial Planner. He believes in proactive tax planning and has the skills, education and experience to demonstrate passionately planned financial strategies. His firm tailors highly efficient tax plans for his small business clients, all in a one on one environment where he and the client can bounce ideas around until every detail is worked out. Located in Orlando, FL, he services all of Florida.
