EBIT and EBITDA: what is the difference?

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Finance pie chartEBIT and EBITDA: what is the difference?

EBIT and EBITDA are two financial measures widely used in business decision making. Let’s compare the two.

EBIT EBIT stands for “Earnings before Interest and Tax”. As the name suggests, it is the entity’s profit after you exclude the effect of interest and tax expenses. EBIT is often seen as a more accurate measure of a firm’s earning potential because it focuses solely on the firm’s ability to make a profit from its operations. Tax and interest are excluded because they are not expenses incurred in the firm’s day to day business operations. Consider the following scenario: • Two companies both commence business with capital of £10,000. • Company A raised its £10,000 by borrowing it from the bank at 20% per annum. • Company B raised its £10,000 by issuing shares to the public. • Company A made a profit of £1,000. Company B made a profit of £3,000. At first glance it appears Company B is 200% more profitable than Company A. However, Company B has no debt whilst Company A is fully financed by debt, and in this example would’ve paid £2,000 in interest. So while Company B appears to have a higher profit, the EBIT of the two companies is exactly the same at £3,000. By using EBIT to compare the two companies, we are able to see that their actual business operations are just as profitable as each other. EBITDA EBITDA takes it a step further and also excludes the non-cash items of depreciation and amortisation. Depreciation and amortisation are used as estimates of the annual cost of fixed assets. By excluding this cost, EBITDA focuses solely on the ability of the firm to generate cash from operations. It does not account for the required investment in fixed assets needed to generate the cash. What is the difference? Both EBIT and EBITDA are indicators of a firm’s ability to generate cash from its operations. EBIT accounts for an approximate cost of fixed assets whereas EBITDA does not. Therefore as a general rule, use EBITDA when comparing firms from different industries. A car manufacturer requires a much larger investment in fixed assets than a restaurant. By using EBITDA, you compare only their ability to generate cash, without accounting for the assets required to operate. For firms within the same industry, EBIT is the favoured indicator as each firms cost of fixed assets should be comparable anyway. Want to know more?  Colour Accounting™ is our financial literacy course.  Click here to secure your place. [traininglist slug=”colour-accounting-normal”]  ]]>

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