Difference Between EBIT and EBITDA

EBIT vs EBITDA
There are different terminologies used in business finance that are used to measure and evaluate the profitability position of a business. You can also use them for comparison with other companies in the same industry as it removes the effect of accounting and financial decisions. EBIT and EBITDA are the example of profitability measures that are used for analysis and comparison.

Earnings before Interest and Tax (EBIT)
Financial analysts and experts often relate Earnings before Interest and Tax (EBIT) with operating income, because their values are very much similar and you can use them interchangeably without giving rise to any accounting discrepancies. However, in the United States, the SEC (Security and Exchange Commission) prohibits the direct comparison between operating income and EBIT, because certain items adjusted in EBIT are not part of operating income. Instead, the commission advises to use net income that is presented in the statement of operations, so as to make EBIT more compatible with GAAP-related figures.

Earnings before Interest, Tax, Depreciation and Amortization (EBITDA)
This measure is often used by capital intensive or highly leveraged businesses where depreciation is calculated very frequently, for example, in a telecommunication or utility business. The reason behind it is that the depreciation rates of these businesses are very high and they pay very large interest on loans, which leave these firms with negative profits. As a result, analysts find it difficult to calculate the value of a business due to these negative figures, and so, they place their reliance upon EBITDA to represent the profits actually available to pay off the loan amount. This is why it appears at the start in the income statement, and gives rise to positive figures in commonly used valuation models.

Accounting for Depreciation and Amortization
EBIT stands for Earnings before Interest and Tax, whereas, EBITDA stands for Earnings before Interest, Tax, Depreciation and Amortization. Although, these measures are not the requirement of GAAP (Generally Accepted Accounting Principles), yet, shareholders and other investors use it to assess the value of a company. As the name suggests, EBIT represents the operating profit of a company before interest and tax, but after accounting for the depreciation. On the other hand, EBITDA computes the profits after accounting for the depreciation and amortization.

Representation of Actual Earnings
Companies with a very small capital expenditure prefer to use EBITDA over EBIT, because the value doesn’t actually matter to them. Therefore, analysts and financial experts can use EBITDA to evaluate businesses in the same industry where the results of CAPEX to Revenue ratios are approximately the same.

On the other hand, the benefit of using EBIT over EBITDA lies in the fact that it recompense the CAPEX (Capital Expenditure) through depreciation to a certain extent. The depreciation amount is actually a sensitive measure of CAPEX as it relates to the assets that are purchased over a period of several years. This is why EBIT gives a better representation of actual earnings as compared to EBITDA, and is a better measure for lenders.

Reasonable Approach for Evaluation and Decision Making
You lose the basic principle of objectivity when you use EBITDA to calculate the value of a business, because the purpose of forecasting the estimated free money is to define the extent of credit risk. Although, credit risk reduces to a greater extent by anticipating higher profits, but it doesn’t take into account the dependence on capital assets to be used as tools for earning profits. So, the risk is always there, but it doesn’t form part of the overall business risk that is used in business evaluation and decision making process.

As already discussed, lenders prefer EBIT over EBITDA, but borrowers prefer EBITDA as it provides a compromise for high risk lending. It shows high projections of available business capital, and so, works in a positive way for the viability of a company as a borrower. Moreover, it also works in favor of lenders by allowing them to give less funds as compared to the value of an asset that is used as collateral.

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