What is the correct way to use the EBIT formula?

Revolut Contributor

 · July 20, 2020  · 07/20/2020

The EBIT is a profit metric which stands for earnings before interest and tax. As the name suggests, it reveals how much profit a business makes over a given period once it deducts all costs from revenue, aside from the interest owed on finance and taxes due. This post advises you how to use the EBIT formula correctly and how this idea differs from operating profit, which is a similar profit metric.

What does EBIT mean?

The EBIT formula provides insight into the performance of a business without, what its proponents argue, are the distractions of expenses not directly controlled by managers (i.e. tax or interest owed).

This figure is keenly observed on financial statements. Even if a business does not directly quote its EBIT – there is no statutory obligation to do so, and the UK's Generally Accepted Accounting Practice (GAAP) guidelines do not cover this metric – it’s easy to calculate, based on other figures routinely provided within income statements.

What is the EBIT formula?

When you think about how to calculate EBIT, it is theoretically plausible to do so in two different ways. The first approach is to take the total revenue of the business for a period and subtract the direct costs and operating expenses over the same time. We cover EBIT in more detail here.

EBIT = Revenue – Direct costs – Operating expenses

The second method is to take the net profit – also known as net earnings – for the same period and add-back the cost of the interest and the tax that the business owes. This alternative version of the EBIT formula, as shown below, is both simpler and typically more accurate than the first approach.

EBIT = Net profit + Interest + Tax

To understand why the last point is valid requires a grasp of how the EBIT differs from operating profit. These two metrics are so similar in nature that people routinely refer to the EBIT as operating profit. Still, even subtle nuances can make a chunky impact in the real-world.

EBIT vs Operating profit: what’s the difference?

The crucial distinction between the two metrics is that to calculate operating profit, you must exclude the value of any expenses or income considered to be ‘non-operational’ from the final answer. By contrast, the EBIT formula should leave these cost categories within the resulting figure.

To illustrate this, let’s look at a few specific examples of non-operational expenses/income and show whether to include each one within the figure for EBIT or operating profit for a given period.

Category of cost or income Operating Profit EBIT
FX gains or losses (i.e. paying for goods/services in a currency different to the
account if the business holds foreign currency in a traditional account)
 NO  YES
Dividend payments received or profits on investments in another business  NO  YES
Rental income or sales profit made on property (i.e. assuming this is not a
core activity of the business)
 NO  YES
Sale of fixed assets at a gain or a loss (e.g. obsolete equipment)  NO  YES
Impairment adjustments to long-term assets (i.e. while checking the allowances
for depreciation or amortisation to reflect true market value)
 NO  YES

For many businesses – in particular, SMEs – the total value of these items is negligible. This is why the EBIT and operating profit get described as synonyms. But if a business routinely holds a decent reserve of foreign currency (and doesn’t have Revolut Business) or it discovers that the value of a patent it holds is today worth far less than it initially estimated, the two profit metrics won’t match.

For this reason, the EBIT formula is best calculated by adding-back interest and tax to the net profits. To derive the answer properly from total revenue (i.e method one of the EBIT formula) you must know the correct values of all non-operational items and this is a big ask for a non-finance professional. It’s smarter to deploy method two.

How do you calculate the EBIT percentage?

It’s easy to convert the absolute monetary value of the EBIT into a ratio and then multiply the result by one hundred to express it as a percentage. The result reveals how much profit, in EBIT terms, the business generates per pound of revenue made. This is the EBIT margin and the formula is below.

EBIT margin = (EBIT/Revenue) x100

Is EBIT the same as net profit?

In a word, no. The net profit is the sum which remains once a business deducts all its expenses from its total revenue for a given period. That said, because net profit does not have a formal definition in the UK, there is ambiguity over what this net profit means here. For instance, whether the term refers to the profit a business made before or after the tax bill is subtracted from its revenue.

The consequence of this ambiguity is that people sometimes use the term ‘net profit’ loosely when they mean the EBIT or another profit metric entirely. It’s always wise to check this detail in meetings.

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