Key Metrics of Financial Health: EBIT & EBITDA
Understanding Your Business Financials: A Deep Dive into EBIT and EBITDA
For most business owners, finding a consistent way to measure and understand financial success is crucial. Whether you're the visionary founder of a tech startup or running a farm full of apple trees, understanding your business's revenue, expenses, profitability, and overall financial health is the foundation for achieving financial goals and securing sustainable success.
At this juncture, many business owners try to navigate the complex world of financial terms and calculations to grasp where their financial success lies. But often, they don’t reach a clear conclusion. For some, it can even feel like trying to escape a maze.
This blog aims to guide you through the maze without getting lost, focusing on two practical financial metrics: EBIT and EBITDA. Let’s dig in.
What's the Difference Between EBIT and EBITDA?
Both EBIT and EBITDA are similar metrics that measure the profitability and efficiency of a company's operations. They diverge in that EBITDA does not include non-cash expenses such as depreciation of company assets in its profitability calculations. This makes for more accurate comparisons between your company and others in your industry.
What is EBIT?
EBIT is an acronym for Earnings Before Interest and Taxes. Essentially, it gauges how profitable a business's core activities are.
Why is this information crucial? Because including interest and taxes can lead to misleading results. For example, you might be restructuring a tax debt. The installments for this restructuring could include past liabilities, skewing your previous year's operational profitability. Alternatively, taking on a loan—unrelated to your core business activities—can distort your genuine profitability.
EBIT can be calculated using two formulas, both of which can be derived easily from your income statement:
- EBIT = Total Revenue - Cost of Goods Sold (COGS) - Operating Expenses
- EBIT = Net Income + Interest + Taxes
For example, let’s say you run an apple farm that generates 1 million EUR in revenue from apple sales in a year. The cost of the sold apples (seeds, water, labor, etc.) is 300,000 EUR, and your operating expenses (rental equipment, administrative costs, etc.) are 200,000 EUR. In this case, calculating your EBIT would result in:
EBIT = 1,000,000 (Total Revenue) - 300,000 (COGS) - 200,000 (Operating Expenses) = 500,000 EUR
What is EBITDA?
Like EBIT, EBITDA is an acronym, standing for Earnings Before Interest, Taxes, Depreciation, and Amortization. This metric measures the same elements as EBIT, but it also removes the impact of non-cash expenses like depreciation.
Calculating EBITDA can help you understand the value of your company in the eyes of banks and investors. It's especially useful for companies with many fixed assets and/or loans.
The formula to calculate EBITDA is:
EBITDA = EBIT + Depreciation Expenses
Or, more broadly:
- EBITDA = Net Income + Interest + Taxes + Depreciation
- EBITDA = Total Revenue - COGS - Operating Expenses + Depreciation
Let's consider a technology startup example. This startup generates 1 million EUR in annual revenue from software sales. Their operational expenses amount to 600,000 EUR, and the cost of sold goods and services (server and support service expenses) is 100,000 EUR. In addition, they also have depreciation costs of 50,000 EUR.
EBITDA = 1,000,000 (Total Revenue) - 100,000 (COGS) - 600,000 (Operating Expenses) + 50,000 (Depreciation) = 350,000 EUR
Conclusion: Grasping the Financial Strength of Your Business
Understanding EBIT and EBITDA can give you valuable insights into the financial health of your business. They allow you to measure how effectively your business is operating and help you make informed decisions. Remember, every business is different, so consider these metrics within the context of your own operations and objectives.