EBIT stands for “earnings before interest and taxes”: the operating profit after depreciation of tangible assets and goodwill, but before interest and taxes. EBITDA (“earnings before interest, taxes, depreciation, and amortization”) is the profit before depreciation and amortization: EBITDA = EBIT + depreciation of tangible assets + amortization of goodwill. EBITDA is often used as a measure of a business’s cash-generating capacity, but it does not take into account necessary replacement investments—one of the reasons why not everyone considers EBITDA to be the best metric.
We see in practice that the terms EBIT and EBITDA are often used arbitrarily in SMEs. However, it is good to know what the difference is and how these terms can be manipulated when buying a business.
What is EBIT?
EBIT (earnings before interest and taxes) is also referred to as operating income after depreciation and amortization (of assets and goodwill). It measures the result from normal business operations. That is, revenue and the costs incurred to generate that revenue (purchases, personnel, rent, insurance, marketing, etc.). Financial results (interest payments or interest income) and taxes are excluded. This is because interest and taxes are not considered operating results, as they are not directly related to the costs incurred to generate a specific amount of revenue.
What is EBITDA?
EBITDA (earnings before interest, taxes, depreciation, and amortization) is the “earnings before interest, taxes, depreciation of tangible assets, and amortization of goodwill.” In other words: EBITDA = EBIT + depreciation of tangible assets + amortization of goodwill. EBITDA is considered a measure of a company’s cash-generating capacity because, unlike EBIT, it excludes depreciation and amortization (non-cash items).
I understand that TMT (Technology, Media, Telecom) and capital-intensive businesses naturally tend to place more emphasis on EBITDA than on, for example, the “old-fashioned” concept of profit. Take, for example, a cable company, which has high depreciation expenses that significantly reduce “traditional” profit.
The preference for EBITDA is then justified by the argument that depreciation of fixed assets and goodwill are purely accounting items, can be influenced by management (after all, estimating economic life is subjective) and do not (or no longer) require cash outlays.
I would like to make a few comments on this though:
#1 First, businesses often do need to continue to invest. This cash out is not directly reflected in the income statement, which maneuvers an important cost item (via depreciation costs) out of the picture. These investments are often not optional but necessary to maintain market position. Those who do not invest run the risk of dropping out. Especially in the TMT sector where today's business models may be obsolete tomorrow. Therefore, in my opinion, depreciation on investments made is still an undeniable part of the bottom line!
#2 In addition, it is important not to compare apples to oranges. Some TMT businesses run all (development) costs through the income statement which reduces EBITDA. While there are also TMT businesses that (obligatorily) capitalize part of their development costs, resulting in a much more profitable EBITDA.
#3 Both EBIT and EBITDA disregard the existing financing structure by excluding interest expenses. After all, the starting point is the optimal financing structure post-transaction. I find this a valid argument when dealing with, for example, a strategic buyer with deep pockets. In the SME sector, however, there are still many heavily leveraged MBO/MBI transactions that are structured using a NEWCO arrangement. In such cases, the target company’s financing structure is certainly relevant.
#4 Even if EBIT is used as a starting point, you still have to pay attention. The correction of depreciation is only representative if there is an ideal complex. In other words, if annual depreciation equals replacement investment. However, what matters is not so much the past investments, but rather the future profitability and the investments needed for that.
What are the average EBITDA multiples by sector?
View the average EBITDA multiples by sector from the Brookz Takeover Barometer (H1 2020) here.
Conclusion
Given the multitude of profit metrics, businesses will often present the one that paints the most favorable picture. Capital-intensive businesses with high depreciation and interest expenses are therefore more likely to opt for EBITDA. As a banker, I prefer EBIT (margin) over EBITDA (margin) because, in my opinion, it makes businesses more comparable. After all, EBIT reflects all operating costs—including the costs associated with using assets in the form of depreciation.
Still, it’s advisable to always look beyond just EBIT or EBITDA. Numbers are merely a reflection of what has taken place within the company. Therefore, evaluate all figures and the trends within them, especially in light of the business model and the associated business risks.
Frequently Asked Questions
What is the difference between EBIT and EBITDA?
EBIT is operating income after depreciation of tangible assets and amortization of goodwill. EBITDA includes these deductions: EBITDA = EBIT + depreciation of tangible assets + amortization of goodwill.
How do you calculate EBITDA?
By adding back depreciation of tangible assets and amortization of goodwill to EBIT: EBITDA = EBIT + depreciation of tangible assets + amortization of goodwill.
Why do some businesses prefer to use EBITDA rather than EBIT?
Capital-intensive businesses and TMT businesses (technology, media, telecom) with high depreciation expenses, in particular, make their earnings look more favorable when using EBITDA, because depreciation is excluded from the calculation.
Is EBITDA a reliable measure of a business’s profitability?
Not necessarily: EBITDA does not take into account necessary replacement investments, which do indeed constitute a real cost item through depreciation.
Why is EBIT preferred when comparing businesses?
Because EBIT does take into account all operating costs, including the costs of using assets in the form of depreciation, it makes it easier to compare businesses with one another.
