Many of you will have sat through operational or finance meetings and will have heard those attending fixating on something called EBIT and EBITDA. You have always intended to ask what it means but by the time the meeting has finished and you have written up the minutes or actions and distributed them to everyone something else has landed in your Inbox or the office interrupter has appeared at your desk for one of their many daily “wee chats”
MEANING
EBIT means “Earnings Before Interest and Taxation”
EBITDA means “Earnings Before Interest and Taxation, Depreciation and Amoritisation”.
Both are measures of profitability however they look at profits in different ways to give what some people claim to be a truer picture of operating profit.
MEASURING PROFIT
Most of you will have heard of “Gross Profit” and “Net Profit”.
“Gross Profit” is the measure of income received less the “Cost of Goods Sold”. The “Cost of Goods Sold” is the direct cost of the goods or service that your operation provides. Take the example of a cell phone retailer (let’s call them Phones4Me). Phones4Me buys cells phones from their supplier at say $300 per unit and sells them to the public at $1000 per unit.
The Gross Profit is therefor “Revenue – Cost of Goods Sold” or in this case $1000 - $300 = $700.
“Net Profit” is the measure of revenues received less all costs incurred, not just the cost of the goods sold. In our example let us assume that Phones4Me has additional costs of $800 to account for General Expenses such as staff salaries/electricity/rates etc, plus Interest on loans taken out, plus Taxation on sales and profit plus an allowance for Depreciation and Amortisation costs (we will look at for Depreciation and Amortisation later in this paper).
The Net Profit is therefor "Revenue – Cost of Goods Sold – Expenses or in this case $1000 - $300 - $800 = -$100.
Using EBIT and EBITDA
Now let’s say that the total of all additional costs was $800 made up of
· Interest $100
· Taxation $90
· Depreciation & Amortisation $150
· General Expenses $460
The EBIT calculation adds Interest and Depreciation back into the equation so EBIT would equal Net Profit of -£100 + Interest ($100) + Taxation ($90) = $90 This is now a positive figure.
The EBITDA calculation adds the allowance of Depreciation and Amortisation back into equation so EBITDA would equal EBIT ($90) + Depreciation & Amortisation ($150) = $240. EBITDA is another positive figure and is also higher than EBIT!
So, your boss is now delighted that EBIT is positive and EBITDA also positive . Backs are being slapped and bonusses are being discussed due to their great performance.
BUT WHY? YOU MADE A LOSS DIDN’T YOU?
Before we progress further we need to clarify some of the definitions being used.
Interest is the amount that the organisation is paying to finance any debt. It is the same as the interest you would pay on an automobile loan or a mortgage
Taxation is simply the amount that the organisation is due to the local tax authorities.
Depreciation and Amortisation is an accounting practice that spreads the cost of capital equipment or other one off expenses over an agreed period (in theory over the useful life of the asset). For example if an organisation paid $900,000 for a new piece of machinery and that piece of machinery had a n estimated useful life of 10 years the organisation may decide not to hit the first year profit & Loss with the full $900,000. It may choose to spread this over the next 10 years, deducting a nominal $90,000 per year. For tangible assets, like a piece of equipment we use the term “Depreciation”, for intangible assets like a patent or goodwill we use the term Amortisation. Otherwise they are treated the same.
SO WHY THE DELIGHT?
Operational Profit
The reason that some bosses fixate over EBIT and EBITDA is that they believe that it gives a better indication of the true operational performance of the business excluding factors that are outside the control of management. For example; management do not dictate the interest rate being paid nor do they set the level of taxation so by excluding these in the EBIT calculation it seems to be a fairer measure, especially if performance is being compared across states or countries where different interest rates and taxation regimes may exist. The argument is that it enables pure operational performance to be compared between similar operations.
Secondly, nominal costs such as depreciation of an asset could be based on a decision taken 5 years previously by a totally different management team. The argument goes that the current operational management team should not have their performance measured based on previous managements’ decisions, or indeed, mistakes. Hence removing depreciation and amortisation costs as well as interest and taxation from the equation will give an even fairer measure of current performance.
A further argument is that certain costs such as interest payments or depreciation will not last for ever. For example, the company loan may be getting paid off in two years’ time or the “useful life” period for a fixed asset is coming to an end so in two years’ time there will be no Interest or Depreciation charges on the books. So the argument is why not recognise that these costs will soon disappear ?
A good analogy is to think of yourself if you own a home and have a mortgage coming to an end. Imagine that for the past 10 years your annual expenses are greater than your income. You are paying off a mortgage with a high interest rate and also a capital repayment and you live in a state / country with high taxation. However, next year your mortgage is going to be paid off and you are moving to Costa Rica. Your salary will remain the same.
Today you might look in horror at you bank statement each month but deep down you know that by this time next year you are going to be financially flush. No more mortgage, no interest payments and lower tax bills, but the same income.
This is similar to what your boss is thinking. Despite the interest and depreciation costs today they know, deep down, that the business is operationally profitable and once these extraneous costs are removed then net profits will increase.
Bearing in mind that EBITDA is always higher than EBIT and EBIT is always higher than Net Profit, what would you rather have your bonus based on?
DANGER
Not everyone agrees with using EBIT or EBITDA being used in this way. Many claim it gives organisations a false sense of security and results in bonus payments that the organisation cannot afford.
Probably the most famous opponent is Warren Buffet who thinks that using EBITDA is like the tooth fairy paying for capital expenditure. Buffet says that organisations will always borrow so will always being paying interest (just for different reasons) and that successful organisations will always be investing in new capital equipment or intangible assets so Depreciation and Amortisation will always be a factor.
Personally, I tend toward Buffet’s thinking. I have seen too many businesses where management have convinced themselves that due to positive EBIT and EBITDA figures, as opposed to a negative Net Profit, that they are operationally sound and that everyone deserves a bonus. I have seen organisations folding for not recognising this.
So next time your boss and colleagues start fixating on EBIT and EBITDA ask yourself if their assumptions are correct…are interest payments going to fall in the future, is taxation abnormally high compared to other states / countries and will there never be the same capital expenditure in the future as there has been historically.
The brave amongst you night also challenge the boss. The boss may just be in what I call “the EBITDA groove”. It is the way they always measure performance, it was the way it was measured when they joined and it has never been changed nor challenged.
Good luck!
About the Author:
Richard Arnott, BA, FInatAM, FIToL, is the Director of BMTG (UK) Ltd, and the author and lead presenter of the groundbreaking, globally recognised Advanced Certificate for the Executive Assistant: ACEA® program. Richard also sits on the editorial board of Lucy Brazier OBE’s Executive Support Magazine
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