What is EBIT and EBITDA in Finance?
EBITDA and EBIT is a very fundamental financial term that is nowadays mostly considered during the cloud adoption phase. If your company is planning to migrate to cloud and you are going to present a finance key performance index to your CFO then make sure you learn these concepts.
Broadly for any company there exist 3 types of financial statements as following:??
Balance Sheet
Balance sheet consists of? Assets and Liabilities.?
Assets are of 2 types Fixed and Current Assets. Fixed Assets which you get the cash value after 1 year example real estate, building,? equipment, vehicles.? Current Assets which you convert into cash within 1 year.
Liabilities are 2 types: Long Term and Current. Long Term liabilities which you have to start paying after 1 year. Current liability which you have to pay off within 1 year.?
Income or Profit & Loss (P&L) Statement
If you subtract your company Expenses from Revenue then you get the profit.?
Profit = Revenue - Expenses
The profit that you make as cash is added to the Current Assets in your Balance Sheet. So if you make more profit your cash reserves increase that increases your assets as well.?
Cash Flow Statement
A Cash Flow Statement is just like your bank account statement that shows how much money is credited (deposited) or debited (withdrawn) from your bank account.?
Net Cash Flows = Cash In - Cash Out?
Cash In could be in any form of money deposit to your bank account it could be loan, income revenue, friend deposit money. Cash out could be any form of withdrawal from your account for any reason. The net balance of your cash is the net cash flows of your account.?
EBIT & EBITDA is a metric of Profit and Loss statement that explains which company stock is good and which company is performing better at an operational level.?Before we learn about EBIT and EBITDA lets learn some more fundamental concepts like depreciation, amortization, non-operational expenses etc. next.
Depreciation and Amortization
Depreciation is the expense of a tangible fixed assets over its useful life.?
Tangible assets are physical assets that can be touched. Example of Tangible assets such as Buildings, Equipments, Furniture, Vehicles, Land, Machinery.?
Amortization is the practice of spreading an intangible asset’s cost over that asset’s useful life.?
Intangible assets are not physical assets, they can not be touched. Example of Intangible assets such as Patents, Franchise agreements, Organizational Costs, Proprietary process such as copyrights like purchasing cost of software license, Bonds, Employees of a company.
Non Operational Expenses
Non operational expenses are the variables that differ company by company. Majorly below 3 categories of expenses are called as non-operational expenses:
EBIT & EBITDA?
EBITDA means Earning Before Interest, Tax, Depreciation and Amortization.??
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EBITDA = Gross Profit - Operating Expenses
Once you remove the Depreciation and Amortization element from EBITDA you get EBIT value.
EBIT = EBITDA - (Depreciation + Amortization)?
Further once you remove the Interest ( in case your company is paying ) then you will receive Profit Before Tax (PBT) value.
PBT = EBIT - Interest
Company's Net Profit can be found once we remove the Tax component from profit before tax.
Net Profit = PBT - Tax
So if you know Net Profit, Tax and Interest values of any company then you can calculate EBIT value by adding Interest and Tax value to the Net Profit value.
EBIT = Net Profit + Interest + Tax?
So if add Interest, Tax, Depreciation and Amortization to the Net Profit you will also get the EBITDA value.
EBITDA = Net Profit + Interest + Tax + Depreciation + Amortization?
Lets take an example of Vehicle Manufacturing Company EBITDA & EBIT values from their Financial Statement:
Why is EBIT and EBITDA important for a company?
The Net Profit of a company doesn't describe the financial status of a company. Because, non operational expenses such as Interest, Tax component, Depreciations, Amortizations vary per company. Example: some companies might have no loan so no interest so they might show more net profit. Other companies have taken larger loans so their interest rate is high so net profit becomes low. Taxes can change as per geographical area. Depreciations may differ per company based on old/new physical assets. Therefore, you should financially compare companies at operational level only.?
In order for creating a Level Playing Field for a given company you will use EBIT & EBITDA that is used to compare companies on their operational costs. That is the recommended way to identify which company is financially stronger.?
EBITDA is mostly considered heavily in capitalized industries like telecommunications, manufacturing, oil & gas etc. industries. Maximum IT companies have hybrid and multi-cloud situations where they do have their own data center (on-premise) so they have depreciations. IT companies also have Amortizations if they are buying licenses and paying monthly.
EBIT is mostly used for service oriented industries like Consulting and Technologies since most of them may not have Depreciation and Amortization values.
Why do C-Level Executives care more about EBITDA??
Cloud computing is an online delivery of IT services via the internet as pay-as-you-go model on an on-demand basis. Since you pay for what resources you consume monthly. Hence your company starts having more Operational Expenses as you move to cloud.?
EBITDA = Gross Profit - Operating Expenses
As your company migrates to the cloud, the operating expenses increase, the EBITDA value decreases. Since your company is saving money by spending less money on capital cost it is good for your company. Cloud gives you agility, scalability, reliability and better business continuity and disaster management facility. Your company can use saved money for innovation and modernization of their existing workload in the cloud.?
In most of the companies, C-Level executives such as CFO, CIO, CEO, CTO, CSO etc. get their incentives, bonus based on their EBITDA value. If a company has larger EBITDA value then c-level executive incentives are large. However, if EBITDA value decreases as you migrate to the cloud then their incentive gets reduced.?
However, IT companies also have data center staff expenses that are being calculated as the operational cost. Since that costs are now reduced or completely removed based on how many data centers your company closes. That value can balance out the EBITDA value and make your c-executives happy in terms of getting good incentives.
Conclusion?
So EBITDA is the term used by many software IT industries to publish their financial growth. You can check Microsoft Azure EBITDA margin over the last 10 years here in this chart?
(Image taken from Microsoft ebitda margin)
I am not finance expert so please share your thoughts, experience and feedback I am happy to learn and update this article.