EBIT vs EBITDA | How to Measure Profitability
Even if you’re a freelancer or business owner who receives 1099s, it is still good knowledge to understand some industry terms like EBIT vs EBITDA. EBIT and EBITDA are common profitability metrics that investors use to measure a company’s ability to make profit. Today, we’ll explore each of these terms and highlight the differences.
EBIT vs EBITDA: Which is better?
There is generally no “better” metric, as there are use cases where EBIT is better and others where EBITDA is better. Generally, EBIT is sufficient and simpler for businesses that are not asset intensive, meaning it doesn’t require a huge amount of machinery or equipment to start/operate. In industries where a large amount of fixed assets are required, like a manufacturing plant, EBITDA would be a much better metric. When in doubt, don’t overcomplicate it. EBIT and EBITDA are essentially the same metrics, except EBITDA address depreciation and amortization.
The reason EBITDA is better for asset intensive businesses is because it excludes depreciation and amortization in its calculation. To simplify, depreciation and amortization are expenses that are incurred to spread out the cost of a large purchase over time, instead of all at once. This is done to adhere to the matching principle in accounting and to ensure proper bookkeeping.
Now let’s define both terms in detail, with examples. We can’t understand the relationship of EBIT vs EBITDA without understanding each term independently and what they represent.
What is EBIT?
EBIT stands for Earnings Before Interest and Taxes and is widely considered a measure of a company’s profitability. EBIT represents a company’s ability to bring in cash from its core operations before deducting its interest expense and tax expense. This is a particularly important metric, because it indicates how successful a company is at turning a profit from its main operations. For example, if a company sells T-shirts, that company’s EBIT figure would represent how much money a company gets to keep after all expenses have been deducted.
It’s worth noting that for many companies that are smaller and not as sophisticated, EBIT often equates to operating profit/income. That is because many small businesses don’t yet have debt and thus, Interest Expense, to “add back” to calculate EBIT and tax expenses are small.
How is EBIT Calculated?
EBIT can be calculated in two ways:
From the top down, always the same as Operating Profit
EBIT = Revenue - Cost of Goods Sold - Operating Expenses (Marketing, SG&A, Wages, etc.)
An example:
A company sells 5,000 t-shirts over the course of 6 months at an ongoing fair. The owner hired a single salesperson for those 6 months and paid $35,000 to handle the event. The owner also had to pay a $5,000 fee to be a vendor at the fair. Additionally, the owner has paid $10,000 to advertise his booth at the fair to generate some traffic. T-shirts sold for $25 each, and it cost $8 each to buy the T-shirts from a manufacturer. To finance all of this, the owner took out a $25,000 loan with an annual interest rate of 5%.
Here’s how the P&L would look from the top down:
Revenue = 5,000 t-shirts x $25 = $125,000
Cost of Goods Sold = 5,000 t-shirts x $8 = $40,000
Gross Profit = $125,000 - $40,000 = $85,000
Operating Expenses:
Wages: $35,0000
Selling Fees: $5,000
Advertising: $10,000
Total Operating Expenses: $50,000
Operating Profit = $85,000 - $50,000 = $35,000
EBIT = $125,000 (revenue) - $40,000 (COGs) - $50,000 (sum of Operating Expenses) = $35,000, same as Operating Profit.
Items below operating profit:
Interest expense = $25,000 (loan amount) x 5% annual interest / 12 (monthly) * 6 (# of months at the fair) = $625
Tax Expense = 30% (assumed tax rate) * $35,000 (operating profit) = $10,500
Net Profit = $35,000 (operating profit) - $625 (interest expense) - $10,500 (tax expense) = $23,875
If calculated top-down, EBIT will always equal Operating Profit. The only time EBIT may not equal Operating Profit is when using the bottom-up approach and there are additional sources of Other Income or Other Expenses above Net Profit. A quick example would be if a business sold an asset, like a piece of machinery and generated some cash. The business does not ordinarily try to generate profits by selling machinery, thus this income would be considered “Other Income”, and not be a part of EBIT. Let’s explore the other method.
From the bottom up
EBIT = Net Profit + Interest Expense + Tax Expense
Let’s use the same scenario as above, but this time with the added implication of sold machinery. Let’s say the business owner of our t-shirt company had decided he wanted to print his own t-shirts and purchased a piece of machinery for $4,000. After registering for the fair, he changed his mind and decided against doing his own printing and sold the machinery. He sold the equipment for $5,000, a $1,000 gain.
Using the bottom-up approach:
EBIT = Net Profit + Interest Expense + Tax Expense
EBIT = $24,875 + $10,500 + $625 = $36,000
You can see that EBIT is different from the first scenario by exactly $1,000, or by exactly the Other Income amount.
What is EBITDA?
EBITDA is actually very similar to EBIT. Except it stands for Earnings before Interest, Taxes, Depreciation and Amortization. The difference lies in the depreciation and amortization portion. As explained above, depreciation and amortization are expenses that coincide with a large purchase. Depreciation and amortization are required expenses with any large purchase in order to spread out the cost over its useful life. For example, a t-shirt printing machine cost $5,000 and has a useful life of 10 years. Instead of being able to take the entire expense all upfront, you have to “depreciate” $500 ($5,000 cost divided by 10 years) each year for 10 years.
How is EBITDA Calculated?
Just like its EBIT counterpart, EBITDA is calculated the same two ways: using a top down approach, or a bottoms up approach. In fact, the calculations are exactly identical except you just “add back” depreciation and amortization. Let’s see this in detail–bringing back our above scenario, with a few tweaks:
EBITDA = EBIT + Depreciation + Amortization
or
EBITDA = Net Profit + Interest Expense + Tax Expense + Depreciation + Amortization
A company sells 5,000 t-shirts over the course of 6 months at an ongoing fair. The owner has decided he will print his own t-shirts using a machine that costs $25,000 with a useful life of 5 years. He also hired a single salesperson for those 6 months and paid $35,000 to handle the event. The owner also had to pay a $5,000 fee to be a vendor at the fair. Additionally, the owner has paid $10,000 to advertise his booth at the fair to generate some traffic. T-shirts sold for $25 each, and it cost $8 each to print the T-shirts. To finance all of this, the owner took out a $25,000 loan with an annual interest rate of 5%. After the event, the business owner then sold his printing machine for $26,000, a $1,000 gain!
Top-down approach
P&L looks exactly the same as above, except this time we will have depreciation expense.
Revenue: $125,000
COGs: $40,000
Wages: $35,000
Selling Fees: $5,000
Advertising: $10,000
Depreciation: $2,500 ($25,000 machine divided 5 years divided by 12 months * 6 months duration)
Operating Profit: $32,500
Interest Expense: $625
Tax Expense: $9,750 (30% of a different operating profit figure)
Other Income: $1,000
Net Profit: $23,125
EBITDA = EBIT + depreciation + amortizationEBITDA = $32,500 (same as operating profit in top-down approach) + $2,500 = $35,000
Bottoms-up approach:
EBITDA = Net Profit + Interest Expense + Tax Expense + Depreciation + Amortization
EBITDA = $36,000
The $1,000 difference again lies in the Other Income, which is included in the bottoms up approach, and not included in the top down approach.
EBIT vs EBITDA: In Summary:
To sum up, here are some key points about EBIT vs EBITDA and important things to remember:
Both EBIT and EBITDA are profitability metrics and are often used to measure a company’s ability to make money
EBIT can be used for industries that are not asset intensive
EBITDA is preferred if the business operates in an industry that is asset intensive
EBIT is always equal to Operating Profit when calculated top down
EBITDA is essentially the same as EBIT, but adding back depreciation and amortization
Neither EBIT nor EBITDA are standard GAAP figures
FAQs:
What is better EBIT or EBITDA?
EBIT is simpler and better for non asset intensive businesses where depreciation and amortization are small factors, like SaaS or services. EBITDA is better and often required for asset intensive businesses like manufacturing since depreciation and amortization can be a significant expense.
Which is better EBIT or net profit?
EBIT is used more often as investors believe it represents the profitability of a company better than net profit. EBIT is money a business make from operating its core business, whereas net profit could include miscellaneous expenses such as interest and anything categorized as “other”.
Is EBIT multiple higher than EBITDA?
EBIT multiples should be higher than EBITDA multiples, because EBITDA will always be higher than EBIT since you’re adding back depreciation and amortization. Multiples are used in valuation and from a valuation standpoint, you need to multiply EBIT more times to reach the same valuation versus using EBITDA, since EBIT is a lower number. Hence, the EBIT multiple will be higher.
