As a small business owner, you’ve probably heard that “you need to spend money to make money.” But, how do you know if the money you put into your business is generating revenue? To measure profitability from operations, look at earnings before interest and taxes (EBIT).
What is EBIT in finance?
Earnings before interest and taxes looks at your business’s profitability by subtracting expenses from revenues. The important thing to keep in mind is that you do not include interest and taxes when calculating EBIT. Earnings before interest and taxes are also called operating profits.
When you leave interest and taxes out of the equation, you remove variables that affect your bottom line in business but do not result from operations. You focus on your ability to generate a profit.
EBIT and net profit
EBIT is on your business’s income statement. The income statement shows how much money your business generates during an accounting period.
Several lines show profit on the income statement. The first figure shows your gross sales, before deducting any expenses. Gross sales exclude all expenses, so it is not an accurate picture of profitability.
Operating profit and net profit are examples of your ability to generate cash. The net profit, or bottom line, is EBIT minus interest and taxes.
Operating profits show how well you make money from cost of goods sold (COGS) and business expenses. Net income is your take-home pay.
You can use ratios to evaluate profitability. Divide EBIT by the total sales to see what percentage of sales are operating profits. And, divide the net profit by the total sales to see what percentage of sales is take-home income.
How to calculate EBIT
To calculate earnings before interest and taxes, start with the gross profit. Subtract operating costs from the gross profits. When calculating EBIT, do not subtract the cost of business capital and tax liabilities. These items are not included in earnings before interest and taxes.
EBIT formula example
The following is an EBIT formula example:
Gross Sales – COGS and Business Expenses = EBIT
You can also calculate EBIT using the net profit. Add interest and taxes to the net profit to find earnings before interest and taxes.
Net Profit + Interest and Taxes = EBIT
Example of EBIT
A business’s EBIT is always a larger value than the bottom line. Take a look at net profit and EBIT on the income statement:
The earnings before interest and taxes were calculated by subtracting the COGS and operating expenses from the total revenue (150,000 – 25,000 – 50,000 = 75,000).
What is EBITDA?
EBITDA is often used by businesses that require a lot of depreciation calculations. These companies have high depreciation rates and large interest payments on debt.
When a business pays a lot of depreciation and interest, the income statement might show a negative net profit. The negative net profit makes small business valuation difficult. EBITDA shows the money available to pay debts and usually gives positive profitability.
How to calculate EBITDA
Calculating EBITDA is similar to finding EBIT. Start with your business’s total sales. Then, subtract the COGS and business expenses. Do not subtract interest, taxes, depreciation, or amortization. In the end, your EBITDA formula will look like this:
Gross Sales – COGS and Business Expenses = EBITDA
You can also calculate EBITDA from the net profit. Add interest, taxes, depreciation, and amortization to the net profit.
Net Profit + Interest, Taxes, Depreciation, and Amortization = EBITDA
Why look at EBIT for your small business?
EBIT gives you a baseline for profitability, but not the whole picture. You can use EBIT to see how much outside financing affects the net income. And, you can use it to measure how well your business is doing compared to industry averages.
Every business has its own tax and capital obligations. These figures can make it difficult to see the actual profitability of the business. One company might have more debt than another. Debt affects the bottom line, but does not reflect performance. EBIT excludes interest and tax liabilities to show you just profits and expenses from operations.
With earnings before interest and taxes, you can compare your business to competitors with different capital structures and tax debts. If you are below industry standards, you might need to change your operations.
EBIT is also important if you’re trying to sell or grow your business. Investors usually want to know your earnings before interest and taxes. Generally, capital structure is less important to investors than your business’s ability to earn a profit.
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