What is Earnings Before Interest and Taxes?

Earnings before interest and taxes is a calculation of the operating earnings of a business. It specifically excludes interest, which is a finance cost, and taxes, which are imposed by a governmental entity. The residual amount is a fair approximation of the current earning power of the operations of a business. The concept is more commonly known by its acronym, which is EBIT.

The use of EBIT is common among industry analysts, because they can use it to ignore the financial effects of the differing capital structures of entities within an industry, and focus on their operational results instead. Similarly, it can be used to ignore the differing tax situations of comparison companies, who may have different effective tax rates, depending on their tax planning activities.

A publicly-held entity may be tempted to report its EBIT in its reporting to the investment community. This is not encouraged by the Securities and Exchange Commission, which mandates that the reporting of any non-GAAP financial measure must be reconciled back to an appropriate GAAP measure (such as net profits).

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Formula for Earnings Before Interest and Taxes

To calculate EBIT, subtract interest expense and income tax expense from net profit. The interest expense should include all interest charges associated with any type of debt, which includes lines of credit, short-term debt, and long-term debt. The EBIT formula is as follows:

Net profit - interest expense - income tax expense = EBIT

The concept should be expanded to also exclude interest income, since this is also not related to operations. Otherwise, a business with a large amount of investments would report an excessive amount of income, rendering its results not comparable to those of similar companies. This situation is most likely to arise for a business that has recently gone public and sold a large amount of stock, resulting in an inordinately large bank balance.

Problems with Earnings Before Interest and Taxes

There are several problems with the earnings before interest and taxes concept, which are as follows:

Ignores financing and tax realities. EBIT excludes interest and taxes, which are real costs businesses face. Ignoring these factors can give a misleading picture of profitability, especially for companies with high debt or operating in high-tax jurisdictions.
Subject to manipulation. EBIT is based on accounting profits, which can be influenced by a variety of accounting policies. These practices can make EBIT less comparable across companies.
No focus on cash flow. EBIT does not reflect a company's ability to generate cash, as it excludes changes in working capital, capital expenditures, or other cash outflows.
Excludes non-operating income. EBIT focuses solely on operating activities, ignoring significant contributions from non-operating income (e.g., investment gains or losses), which might be a material part of a company's overall profitability.
Overlooks capital structure differences. Companies with similar EBIT figures may have drastically different net income or cash flow depending on their capital structures, interest rates, or tax obligations.