Regulatory agencies and researchers have long recommended investors look beyond earnings to more valuable financial metrics. When it comes to measuring a company’s performance, many investors prefer net income. But is net income the best metric for comparing competitors? A comparison of EBITDA and EBIT may help you decide which is better after reading about how each one is calculated.
Types of Profitability Metrics
Earnings (or net income) is the bottom line of a company’s profit and loss statement (also called an income statement). It represents the sum of all revenue less all expenses, including taxes. Earnings can also be calculated using cash flow statements that include depreciation and amortization; these are called “cash earnings.” However, EBITDA and EBIT are more common profitability metrics.
Cash Earnings vs. Accrual Earnings
One reason why some people prefer using cash-based measures like EBITDA is because they believe accrual earnings (which include depreciation and amortization) do not accurately reflect a company’s performance. Accrual earnings are subject to the differences in non-cash depreciation and amortization policies that companies use, as well as assumptions on useful life of their assets.
What Is EBITDA?
EBITDA stands for “earnings before interest, taxes, depreciation and amortization.” It is used to measure a company’s operating cash flow and is calculated as:
EBITDA = Operating Income + Depreciation and Amortization − Interest Expense + Non-Operating Items (Ex: Restructuring Charges)
Investors like EBITDA because it shows how much money a company earns without the effects of tax rates, accounting methods and capital structure. EBITDA is particularly useful for comparing companies in different industries with varying tax rates because it shows cash flow from operations before taxes.
What Is EBIT?
Like EBITDA, EBIT stands for “earnings before interest and taxes.” It is calculated as:
EBIT = Operating Income + Interest Expense − Depreciation and Amortization − Non-Operating Items (Ex: Restructuring Charges)
EBIT is preferred by some analysts because they believe it shows cash flow generated or used by a company’s operations before the effects of accounting methods and capital structure. As with EBITDA, it is less affected than net income by differences in tax rates and artificial accounting costs such as depreciation.
Which Is More Accurate?
Both EBITDA and EBIT are useful ways of measuring a company’s profitability, but they may not always tell you what you want to know. Remember that the point of investing is to make money; if you buy stock in Company A thinking it will be more profitable than Company B, you might want to look at each company’s net income instead of EBITDA. Furthermore, companies have different depreciation and amortization policies, so a comparison of EBIT or EBITDA cannot be used to compare profitability for all companies.
In the 1990s, American Airlines believed their planes had a longer useful life than industry-standard when they calculated depreciation for their financial statements. American Airlines used shorter depreciation periods when they should have been using longer ones, so they appeared to be more profitable than competitors when in fact it was simply an accounting illusion.
EBITDA and EBIT are also not a good measure of a company’s ability to pay interest or generate free cash flow because they do not account for the level of debt on the balance sheet. To measure a company’s ability to pay back its debt, you want to look at free cash flow or EBTIDA minus interest expense. The point is that both metrics have strengths and weaknesses and should be considered together when looking at a company’s performance rather than used independently.
Some companies prefer not to use EBITDA or EBIT because they fear these metrics do not provide enough of a realistic picture of their performance. Instead, companies may want to disclose metrics that show the contribution of every segment.
Reported Earnings vs. Cash Earnings
Some analysts believe it is important to look at all sales and expenses when evaluating a company’s performance because reported earnings can be affected by transactions that are not necessarily related to the company’s core operations, such as weather disasters or currency fluctuations. These analysts believe it is more useful to look at a company’s cash earnings, which exclude transaction-related expenses and instead focus on what they call “tough-to-manipulate items” such as EBITDA and depreciation.
Investors should keep in mind, though, that reported earnings are required by the U.S. Securities and Exchange Commission (SEC) to have a greater focus on cash flow from operations than on historical costs. While it is useful to look at transactions that occurred during a certain period, you cannot remove them from reported earnings.
The Bottom Line
EBITDA and EBIT are useful ways to compare the performance of different companies, but should not be used alone. Both metrics can be further broken down into more specific measures linked to a company’s operations. Remember that an individual metric may not tell you what you want to know about a company’s performance, so it is important to look at several different measures together. Furthermore, while EBITDA and EBIT do not include all of the items that may affect a company’s cash flow, some analysts believe that they provide more realistic measurements than reported earnings or cash earnings.