Dear Owner:
My blog has really focused on increasing corporate value through risk reduction and I will continue to preach this value gospel, however, reviewing “income”, earnings” or “profit” definitions that comprise these terms are necessary to ensure we are talking about the same cash flow stream. Further, it is hoped that you will be able to better identify which income definition is best suited for your company.
EAT: earnings after tax. All definitions start with earnings after tax. In my opinion, this is the Holy Grail of definitions. As we say in hunt camp, “You EAT what you kill!” and in business it is the same; you only can spend what you get after tax. It is the last word on the profitability of your company. That being said, there is good reason to have other definitions for comparability among companies.
EBT: earnings before tax. This is a profitability measure that excludes the impact or decision making in tax planning. When there is a need to compare companies and the manner in which taxes are planned for are not relevant; EBT is used. For example, private companies plan for tax minimization, public companies typically do not or to compare companies in different taxing jurisdictions, EBT may be preferred.
EBIT: earnings before interest and tax. EBIT is EBT with interest added back. Many practitioners refer to EBIT as operating income. It is the profitability indicator without consideration for how you have organized your capital structure in terms of debt and equity. In comparing firms, capital structure (the mix of debt and equity) is a management decision that can be viewed as discretionary not dependent on operations. If so, EBIT is a valuable tool for making comparative decision when you want to take tax and leverage out of the equation. EBIT tells the practitioner about operational profitability.
EBITDA: earnings before interest, tax, depreciation and amortization. EBITDA is EBIT before the consideration for depreciation and amortization; these accounts are added back to EBIT. EBITDA focuses comparability between companies to operational cash flow. Depreciation and amortization are accounting entries to recognize the decrease in useful life of assets already purchased. They are non-cash flow items in the income statement and therefore are added back to get a picture on the cash generated from the company.
These are commonly used definitions for income used for various internal analysis applicable to the metrics specific of a business and/or industry. A service company with no material tangible assets to amortize will have EBIT and EBITDA materially no different and thus may derive a higher comparable benefit using EBIT. Companies with high tangible asset levels will have large depreciation charges potentially yielding different income results if different amortization rates are used, so EBITDA may be preferable.
What you should notice as you move away from the bottom line, the income analysis sheds away decisions you have made to not only operate the company, but structure it for production and capitalization as well as tax planning. Notwithstanding various income definitions can add comparative value, to maximize the sale of your business, the best decisions have to be beyond the operations but in the capital structure, investment and tax decisions. Even in defining income, non operational decisions have influence.
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