EBIT and EBITDA: What Do They Mean?

EBIT stands for Earnings Before Interest and Taxes.

EBITDA takes it a step further and includes Depreciation and Amortization.

Both are metrics to show a company's profitability or performance. They're often used in acquisition negotiations.

The concepts of EBIT and EBITDA became popular in the 1980s, a period marked by many leveraged buyouts. A leveraged buyout is a financing method where a company's acquisition mainly relies on borrowed money, which the acquired company must repay later. The assets of the acquired company are used as collateral for the loan. At that time, EBIT and EBITDA were seen as measures of the company's ability to repay its debts. Over time, EBITDA became popular in capital-intensive sectors where assets are depreciated over a long period.

Clear Interpretation

In Belgian financial statements, these terms don't appear, leading to interpretation issues about what EBIT and EBITDA mean. There are also no official rules worldwide that precisely define EBIT and EBITDA.

The Commission for Accounting Standards (CBN), a Belgian advisory body that interprets and comments on complex accounts as a guide for accounting experts, wanted to address these interpretation difficulties. They worked on a technical note that defines EBIT and EBITDA based on the Belgian accounting scheme.

EBIT can be equated with ‘operating profit or loss’. This is the profit before financial income and expenses, and before taxes. It disregards whether the company has large or small debts and consequently pays high or low interest. The tax burden also doesn't play a role.

EBITDA takes it a step further and also disregards costs that aren’t actual expenses (the so-called non-cash items), such as depreciation and amortization.

What is the use of EBIT and EBITDA?

EBIT and EBITDA can be useful for comparing companies. How does one company perform compared to another in the same sector? By calculating the EBITDA of various companies within the same sector, businesses can be better compared.

Furthermore, proponents see EBITDA as a quick way to determine a company's creditworthiness. At the same time, according to advocates, it provides a good picture of the company's ability to generate cash.

Critics, however, find using EBITDA too short-sighted to value a company. There are significant differences between companies depending on their location and tax burden. They also refer to EBITDA as the result before accounting for the numbers that matter. Profitability cannot be derived from EBITDA, and it provides a distorted view of cash flows because taxes and interest also cause cash movements. EBITDA also measures profit inaccurately because capital carries costs, and assets eventually need to be renewed. EBITDA does not account for this.

Caution Needed

It's clear that caution is needed when discussing EBIT and EBITDA. They can provide a first indication of a company's profitability but do not consider taxes and interest, nor the outgoing cash flow associated with (replacement) investments.

Schematic Positioning of EBITDA and EBIT in the Income Statement:

Revenue
- minus Purchases of trade goods, raw materials, and supplies
= gross profit

- minus Services and miscellaneous goods
= added value

- minus Salaries, social security, and pensions; other costs and revenues
= EBITDA (or operating cash flow or company cash flow)

- minus Depreciation and amortization
= EBIT (or operating result or operating profit)

+ Plus or - minus Financial income and costs
= Profit before taxes

- minus Taxes
= net profit