What is EBITA?
Earnings before interest, taxes, and amortization is a measure of the company’s profitability used by investors. The information obtained from EBITA is necessary for comparing two or more companies in the same line of business.
Most investors and analysts assert that a company’s EBITA gives the most accurate representation of its earnings. It excludes the taxes owed, interest on debt, and the effects of amortization.
One benefit you can expect from EBITA is that it clearly reveals the available cash flow that the company can reinvest in the business or settle its dividend obligation. Furthermore, the measure is considered a way of gauging the company’s obligations.
Calculating EBITA requires that you first get the earnings before tax (EBT). This figure is extracted from the incoming statement and other financial reports provided to investors. Add to the figure the amortization and interest expenses.
The formula for EBITA is shown below:
EBITA = EBT + interest expense + amortization expense
Understanding the three EBITA components
1. What is EBT?
Earnings before tax (EBT) is a tool used to measure the financial performance of a company. It shows the earnings the company gained prior to a tax deduction. To calculate EBT, less all expenses except taxes from revenue. The figure can be found as a line on the income statement.
Other terms used to describe EBT include pretax income, income before income taxes, or profit before tax.
EBT is an important figure because it removes the effects of taxes on a company’s operations and can show how the company is performing compared to peers.
The process for calculating EBT is the same across all companies. The amount found is a pure ratio, meaning that computations are done based purely on the numbers found from the income statement. Accountants and analysts extract EBT from this statement, from which they deduct interest, interest, administrative expenses, cost of goods sold, and other operating expenses from the gross sales.
Once the company has its gross revenue, it adds all its operating costs and subtracts the figure from the gross. Different components make up the operating costs, including salaries, wages, rent, and general overhead expenses.
For a technology company that has a substantial investment in human capital, you need to deduct the salaries expense and any interest expenses from gross revenue.
EBT can be viewed as a tool for comparison in the same way that EBITA is. The financial figure takes away the effects of taxes when comparing how different businesses performed in a certain financial period. That is an important exclusion since U.S. businesses, for example, can have the same taxes at the federal level but face different taxes at the state level.
Considering that businesses could be paying different tax rates, EBT helps investors to assess the profitability of businesses in different tax jurisdictions. Additionally, EBT can calculate other performance metrics like pretax profit margin.
Earnings before tax (EBT) is the same as income before tax. Both terms can be used since they mean the same thing.
2. What is interest expense?
Interest expense is one of the components that makes it to your calculations for EBITA. Interest expense is the cost that an entity incurs for borrowed funds. The non-operating expense shows up on the income statement. It stands for interest payable on loans, lines of credit, convertible debt, or bonds.
Interest expense is normally calculated as the interest rate multiplied by the outstanding principal amount of the debt. The income statement’s interest rate represents the interest rate accumulated over the period referred to by the financial statement and not the amount of interest paid during that period. Companies’ interest rate is tax-deductible. The same is dependent on jurisdiction when it comes to individuals case.
Interest rates normally show up as a line item on the company’s balance sheet because there are usually timing differences between interest paid and interest accrued. Interest that has accrued but not been paid shows up in the current liabilities section of the balance sheet. On the other hand, interest paid in advance appears on the current assets section of the prepaid items.
Companies with debt will pay different amounts of interest rates as determined by the levels of interest rates in the economy. Interest rates tend to increase during inflation and reduce to the lower side in periods of muted inflation.
A company’s profitability is directly affected by the amount of interest expense. The effect is felt mostly by companies with huge debt loads. Economic downturns can make it quite difficult for heavily indebted companies to service their debts. An investor and analyst will mainly concentrate on solvency ratios like interest coverage and debt to equity during such times.
Interest coverage is the ratio of a company’s operating income (EBIT) to its interest expense. The ratio shows the company’s ability to meet its interest expenses with its operating income. The higher the ratio, the better the company is positioned to cover its interest expense.
For example, assume that Company XYZ has a $100 million debt whose interest rate is 8%. Such a company has to pay $8 million per annum in interest expenses. If the annual EBIT is $80 million, the interest coverage is 10, meaning that XYZ can comfortably pay its interest obligations. On the other hand, if EBIT is $24 million, the interest coverage falls down to 3, and such a company would have a hard time staying solvent. Such a company is a red flag for investors.
To sum up, interest expense is an accounting item incurred as a result of servicing debt. Interest expenses tend to have favorable tax treatments.
3. What is amortization expense?
Amortization is an accounting process in which the costs of using a long-term asset are spread over the period during which the long-term asset is expected to generate value. Amortization expenses cover the costs of long-term assets like vehicles and computers during the lifetime of their use. Financial professionals also call it depreciation expenses which can be found on the company’s income statement.
Charging an amortization expense on the income statement reduces the value of the long-term asset on the balance sheet with the same amount. The method will go on until the asset cost is fully expensed or the asset is replaced or sold. The term depletion may be considered the same as amortization, but it focuses entirely on natural resources like timber and minerals.
Amortization is a non-cash expense meaning that it does not need cash outflow but instead reduces the value of an asset. Considering that the expense has already been incurred, amortization has no effect on the company’s liquidity.
The amortization expense is normally recorded on the income statement. It reduces the earnings before tax, hence the tax that a company has to pay. That is why the formula for EBITA involves adding amortization to it.
Non-cash expenses like depreciation and amortization are not included when calculating the performance of a company since they do not have a direct link to the ability of a company to meet its financial obligations and cash flow. Instead, such assessment is done using EBITDA (earnings before interest, taxes, depreciation, and amortization), which has a direct relationship with the company’s financial health.
Amortization is an important tool when it comes to taxation. Most jurisdictions require companies to amortize the expenses of long-term assets over their lifetime and use the same in claiming capital cost allowance.
A company can either defer or accelerate some amortization as a way of optimizing its tax liability.
One thing to remember is that amortization for taxation does not necessarily represent the costs a company incurred on its long-term assets. Financial experts accept the use of parallel amortization, which gives an accurate picture of the decline in an asset’s value.
As far as amortization is concerned, the whole focus is normally on tangible assets. Intangible assets like goodwill and trademark exist as long as the business is active. Such assets cannot be depreciated on the balance sheet. However, their value can be reassessed.
EBITA Vs. EBITDA
The formula for EBITA is EBT + interest expense + amortization expense. Conversely, EBITDA has two distinct formulas:
EBITDA = Net Income + Taxes + Interest Expense + Depreciation & Amortization, and EBITDA = Operating Income + Depreciation & Amortization.
EBITDA, short form for earnings before interest, taxes, depreciation, and amortization, measures the profitability of the net income of a company. EBITDA removes non-cash depreciation, amortization expense, taxes, and debt costs in an attempt to get cash profit generated by the company’s operations.
EBITDA does not form part of the generally accepted accounting principles (GAAP). However, some companies often report EBITDA in their quarterly results, excluding additional costs like stock-based compensation.
As investors and companies focus more on EBITDA, some experts have expressed concern that it could be overstating profitability. For that reason, the U.S. Securities and Exchange Commission mandates companies that report EBITDA to also workings how it was derived from the net income. Furthermore, companies are stopped from reporting per-share basis.
Some companies do not report EBITDA. In this case, the metric can be easily calculated from the financial statements using the formulas shown above.
The income statement will provide net income, tax, and interest numbers, while the cash flow statement has depreciation and amortization figures. The easiest way to calculate EBITDA is to start with operating profit (earnings before interest and taxes - EBIT) and then add back amortization and depreciation.
EBITDA represents the net income, in which case taxes, interest, amortization, and depreciation are added back. Investors typically rely on EBITDA as a tool for the trucking and comparing the profitability of companies with depreciation and financing choices notwithstanding.
Similar to earnings, EBITDA is used in valuation ratios. The most notable combination is with enterprise value as enterprise multiple (EV/ EBITDA).
Asset-intensive industries that have a lot of equipment, plant, and property widely use EBITDA. The costs that EBITDA excludes in such sectors can easily obscure changes in profitability, for instance, in the case of energy pipelines.
At the same time, amortization has an important role in software development and other intellectual property. The sector uses this tool for expensing purposes. That is why initial research and technology development stages count for EBITDA as a measure of performance.
Since EBITDA is a non-GAAP measure, its method of calculation can vary from one company to another. Most companies may insist on EBITDA than net income since the former creates a positive image.
EBITA and GAAP
GAAP is a short form for generally accepted accounting principles. Just as the name suggests, it is a set of standards that companies and accounting departments use. GAAP earnings play an important role in standardizing financial reporting by publicly traded companies.
Some companies can have both GAAP earnings and non-GAAP earnings in their reports. The main reason for using non-GAAP earnings is that some one-off costs, like organizational restructuring, can distort the true picture of a company’s financials and should not be considered a normal operational cost.
EBITA and EBITDA are the two most common examples of non-GAAP financial measures. It is important that investors make their decision based on GAAP earnings. These standard accounting rules ensure that investors can accurately compare the performance of competing companies.
Most companies are more likely to insist on EBITA than other GAAP earnings measures because of the way EBITA makes them look good. However, that does not mean they are at leeway to state their performance without some form of regulation. The U.S. SEC has continuously pressured them to be transparent regarding their GAAP vs. non-GAAP earnings.
EBITA is an important metric for understanding a company’s profitability. Even if a company does not state this metric on its financial reports (Not obligated to do so), you can still calculate it from the financial statements. The information needed to calculate will be found in the earnings, tax, and interest section. You will also get the amortization in the notes, completing everything you need to calculate EBITA using the formula EBITA = EBT + interest expense + amortization expense.