Understanding the differences between EBIT vs net income is important for making informed and sound financial decisions regarding whether to invest or to make internal control decisions to better a company’s operations. The comparison between these two metrics is important as it helps a business to know where the information derived from them should be applied. This is because there are drawbacks associated with using only a specific metric.
For instance, taking only EBIT cannot give stakeholders information with regard to a company’s capital structure through the interest paid or the amount of taxes paid, as well as other non-operating expenses. In this article, we see what net income and EBIT connote, their differences, and their similarities.
What is net income?
Net income is defined as the amount of revenue that is left over after accounting for all expenses. In other words, this evaluates the total profits that an entity earns after making necessary adjustments for expenses including interests and taxes.
The major calculation of net profit is carried out by deducting the interests, taxes, depreciation of the financial assets, and other expenses that the company incurs from the total revenue (net revenue specifically) it earns during the same accounting period.
Although, many small businesses do not start calculating their profitability until investors and lenders force them to do so as keeping track of net income is one of the best ways to monitor the financial health of a business. An increasing net income is an indication that the business is on the right track. If the net income is decreasing on the other hand, then it calls for the need to cut costs.
This figure is important to lenders and investors. Here, lenders will want to make sure that a business has enough money to pay back its debts while investors will want to know the money that will be left over for a business to pay dividends, reinvest in the business, or set aside for other purposes.
In calculating net income, there is a need for most business owners to create an income statement (also called the profit and loss statement or P&L account) which is one of the three main financial statements of a business. With this, the aim of a company’s income statement is to show how it arrived at its net income.
In the profit and loss statement, one takes the figure by taking the total revenue for that period which is usually the first item or top line of the statement, then subtract each expense or loss line item by line item until the net income is extracted on the very last line. For this reason, the net income is said to be the bottom line of the income statement.
What is EBIT?
EBIT is an abbreviation that is used for earnings before interest and taxes. It is simply a company’s net income before accounting for interest and tax expenses. This figure is used to measure a firm’s operating performance with respect to its profitability before taking interest, taxes, or cost of capital into consideration. This metric also evaluates a firm’s profitability.
As the name implies, this figure’s calculation ignores interest and taxes. It can be calculated in two ways, that is either by deducting the operating expenses of the company from the net revenues it earned or by adding up the net income, interest, and taxes of a company. EBIT is also known as operating earnings or operating profit.
The EBIT calculation is carried out by taking a company’s cost of manufacturing including raw materials and total operating expenses such as employee wages and salaries. These items are usually subtracted from revenue (net).
The first step taken in carrying out this calculation is to take the value of revenue or sales from the top of the income statement. Secondly, subtract the cost of goods sold from the revenue or net sales which will bring about the gross profit. Lastly, subtract the firm’s operating expenses from the gross profit to arrive at the EBIT.
Having looked at this, the EBIT measures the profit generated by a company from its operations, for this, EBIT is also called the operating profit. By ignoring taxes and interest expenses, the earnings before interests and taxes focus solely on the company’s ability to generate sufficient earnings from operations, ignoring the tax variable as well as the capital structure. This metric is useful because it helps in identifying a company’s ability to generate enough earnings to be profitable, pay off debts, and fund ongoing operations.
This figure is also useful to investors who are comparing multiple companies with different tax situations. For example, if an investor is thinking of buying stock in a company, earnings before interests and taxes can help immensely in identifying the operating profit of the company without factoring taxes into the analysis. Generally, if a company receives a tax break or there was a cut in corporate taxes, there will be an increase in a company’s net income/net profit. EBIT however, removes the benefits from the tax cut from the analysis. This figure is helpful when investors are making comparisons between two companies within the same industry but with different tax rates.
Another area in which the EBIT figure is helpful is in the analysis of companies that are in capital-intensive industries, that is, companies that have a significant amount of fixed assets on their balance sheets. Fixed assets include physical property, plant, and equipment, and they are typically obtained through debt financing. Examples of capital-intensive industries are companies in the oil and gas industry because it is necessary to finance their drilling equipment and oil rigs.
Because of this, capital-intensive industries incur high-interest expenses because of the large amount of debt on their balance sheets. If however, the debt is managed properly, then it is necessary for the long-term growth of companies in the industry. Companies in capital-intensive industries might have more or less debt when compared to each other and because of this, they might have more or fewer interest expenses when compared to each other. Earnings before interest and taxes, therefore, help investors in the analysis of companies operating performance and earnings potential while stripping out debt and the resultant interest expense.
Related: Loss on Income Statement
Net income vs EBIT differences
The key differences that exist between net income and earnings before interests and taxes are as follows:
- One of the key differences between net income and EBIT is the area of interest and tax payments. Net income is an indicator that calculates a company’s total earnings after paying interest expenses and taxes. Earnings before interest and taxes on the other hand is an indicator that calculates a company’s income which is mostly operating income, before paying the interest expenses and taxes.
- Net profit is used in finding the company’s earnings per share (EPS) while EBIT on the other hand is a metric that is used as an indicator to determine the total profit-making capability of a firm.
- The net income calculation is carried out by subtracting the overall cost of running the business from revenue. EBIT on the other hand is calculated by subtracting operating expenses from revenue or adding interests and taxes to the net income.
- Net earnings make use of the whole income that a company generates and takes into account all expenses incurred by the company while the calculation takes place and can be used in making important financial decisions. With earnings before interests and taxes, it is usually very tough to make important financial decisions by depending on it because even though it shows the company’s profitability, it does not consider the big picture. For instance, EBIT does not calculate using the whole non-operating income and does not include taxes and interests.
- Equity investors make use of net income as it is mostly used to calculate the earnings per share of the company. EBIT on the other hand is an indicator that almost everyone who is interested in the company makes use of.
- Net income is simply calculated with the aim of determining the total or final income that an entity earns after paying off its interest and tax expenses. EBIT, on the other hand, is calculated in order to determine a company’s operating income prior to the payment of interest and taxes.
- Net income takes into consideration the cost of operating a business such as taxes, interests, depreciation of fixed assets, and other expenses that the business bears or incurs while performing its business operations. Earnings before interest and taxes on the other hand take into consideration operating expenses such as office rent, insurance, employees’ wages and salaries, electricity bills, printing and stationery bills, utility expenses, etc.
- The calculation of net income is carried out after the calculation of EBIT.
Net income vs EBIT comparison chart
The differences between net income vs EBIT are shown in the table below:
|Basis for comparison||Net income||EBIT|
|Definition||Net income is defined as the amount of revenue that is left over after accounting for all expenses. It is an indicator that is used in calculating the total earnings of a company.||EBIT is simply a company’s net income before accounting for interest and tax expenses. It is an indicator that is used in calculating a company’s profit when taking into consideration the operating income.|
|Their purpose and uses||Used in calculating earnings per share (EPS) of a company||Used in calculating a company’s profit-making capability of a company.|
|Calculation/Formula||Net income = Revenue – All expenses (or cost of doing business)||EBIT = Net revenue – Operating expenses or EBIT = Net income + Interest expenses + Tax expenses.|
|Result||Calculation of the company’s total earnings after making payments of interest and taxes. Hence, it depicts the final or total income that an entity makes after making necessary adjustments for expenses like interests and taxes.||Calculation of income generated by a company mostly by operations prior to the payment of interests and taxes. Hence, the figure depicts the income or operating income that an entity earns before settling off the adjustments that pertain to expenses like interest and taxes.|
|People who make use of it||Mostly equity investors||Usually the government and investors in equity and debt.|
|Order of evaluation||Net income otherwise known as net profit or net earnings is calculated after the determination of the EBIT figure. It is calculated after the determination of earnings before taxes (EBT)||Earnings before interests and taxes (EBIT) is calculated before net income is calculated. It is calculated after determining earnings before interest, tax, depreciation, and amortization (EBITDA) and before determining the figure of earnings before tax (EBT).|
|Interest and taxes||Net income is usually derived by making all necessary adjustments that pertain to the interest and taxes that an entity incurs.||Earnings before interest and taxes (EBIT) do not take into due consideration the interests and expenses that the company incurs.|
|Cost of operating business||Net income considers this. The cost of carrying out a business operation includes expenses such as taxes, interest, depreciation, and other expenses that an entity incurs in the course of delivering its business activities.||Under this metric, this tends to be ignored.|
|Operating expenses||They are not considered here since they are already taken into account in the calculation of earnings before tax (EBIT).||Operating expenses are considered, they include expenses such as office rent, employees’ salary, electricity bills, insurance, cost of inventory, etc.|
Net income vs EBIT calculation and examples
Net income example
Net income has been considered the bottom line of an income statement as it represents the residual earnings of a company, it is inclusive of all operating and non-operating expenses incurred during a given accounting period. Before looking at an example of its calculation, let us look at the key components that must be included in the net income calculation.
- Cost of goods sold (COGS): This is the direct cost that is related to a company’s core operations generating revenue.
- Operating expenses (OpEx): Operating expenses refer to the indirect costs that are related to the company’s operations such as selling, general, and administrative expenses (SG&A).
- Non-operating costs, net: These are the expenses that are not related to the core operations of the company, net of any non-operating income such as marketable securities and short-term investments.
- Taxes: Tax expenses include local, state, and federal taxes that are owed and paid to the government.
Since each line item that appears above net profit such as revenue and expenses is recorded under the accrual method of accounting, the metric is also considered a measure of the accounting profits of a company.
In order to understand the calculation, one needs to start by calculating the gross profit which is obtained by subtracting the cost of goods sold from the revenue. Note that only the net revenue or net sales are considered for the foundation of this calculation.
There are situations whereby a business owner sells goods to customers and return some of those goods due to some reasons like product defect, mismatch, etc. These returns are called sales returns. Sometimes, the buyer may accept these products for a lower price. So, the difference between the actual sales price and the price the buyer agrees to accept the product is referred to as allowance. In essence, sales returns and allowances, and other sales discounts are subtracted from the actual sales or revenue that is generated by the company.
After this, the operating income of a company can be determined by subtracting operating expenses from the gross profit that was calculated. The next calculation that takes place is the pre-tax income (EBT), which is determined by subtracting interest from the operating. The EBT calculation is rare. At this point, one can arrive at the net income by subtracting tax expense from the EBT or pre-tax income.
In order to avoid confusion regarding the net income calculation, we simply subtract all expenses (total expenses) from total revenue as represented in the formula below:
Net Income = Total Revenue — Total Expenses
The formula can be broken down or represented in a more detailed form as follows:
Net Income = Gross Profit — Operating Expenses — Other Business Expenses — Taxes — Interest on Debt + Other Income
Let us see the example below:
Assuming a company generated 1.5 million in revenue and had other costs or expenses and other income as follows:
- Cost of goods sold of $650,000
- Operating expenses of $250,000
- Debt payments of $20,000
- Tax payments of $10,000
- Interest income of $13,000
The net income calculation will be calculated as follows:
Gross profit = $1,500,000 -$650,000 = $850,000
Operating income = $850,000 – $250,000 = $600,000
Net income = $600,000 – ($20,000 + $10,000) + $13,000
Net income = $570,000 + $13,000 = $583,000
Or the calculation can be done at once as follows:
Net income = $1,500,000 – ($650,000 + $250,000 + $20,000 + $10,000) + $13,000
Net income = $1,500,000 – 930,000 + $13,000
Net income = $570,000 + $13,000 = $583,000
An income statement can be prepared to carry out this calculation, the same figure will be arrived at.
Earnings before interest and taxes comprise three vital components that must be considered in the calculation as follows:
- Earnings: This is the amount of income that a company generates after subtracting operating expenses from the total revenue. It is important to note that the cost of sales and the gross profit are derived before arriving at the earnings figure.
- Interest: It is a common factor for a company with many fixed assets on its statement of financial position to finance those assets with debt and this will require that the company makes interest payments. EBIT, therefore, does not deduct interest from earnings which makes it easier to compare different companies that have different capital structures and interest expenses.
- Taxes: The calculation of EBIT does not deduct taxes from earnings because tax expenses do not necessarily depict the performance of a business. For example, tax rates vary across the locations of companies.
Either of the following formulas can be used to calculate a company’s earnings before interests and taxes.
EBIT = Net income + Interest + Taxes
EBIT = Revenue – COGS – Operating expenses
In the second formula, since subtracting the cost of goods sold from revenue is equal to the company’s gross profit, it can be simplified further like this:
Since subtracting COGS from revenue equals a company’s gross profit, you could simplify the second formula even further:
EBIT = Gross profit – Operating expenses
In carrying out this calculation, the first step is to establish the total revenue or net sales which can be found on the income statement. It can be listed as the total revenue or net sales depending on the business type and the structure of the income statement (P&L).
Secondly, one needs to calculate the cost of goods sold which is the cost of material, labor, and production that goes into the company’s merchandise. The cost of goods sold is determined by adding the cost of beginning inventory to any additional inventory that has been purchased over time, then subtract any sold inventory.
The next step is to establish the company’s operating expenses. These are the business costs that are related to the daily operations of the business. These operating expenses are not directly tied to production. This figure is also available on a company’s income statement. Oftentimes, the operating expenses will be itemized into categories such as selling and administrative expenses.
Finally, the company’s EBIT can be calculated after taking the previous steps.
Let us consider the following example:
Assuming that a company has a current total revenue of $38,000, the cost of goods sold is $11,000, and the total operating expenses as outlined on the income statement amount to $7,000. The calculation using the first formula will be as follows:
EBIT = (total revenue) – (cost of goods sold) – (operating expenses)
EBIT = $38,000 – $11,000 – $7,000 = $20,000
To calculate EBIT using net income, the first step is to determine the net income which is seen on the bottom line of a company’s income statement. Secondly, look out for interest and taxes as they are usually listed separately on the income statement. From there, the EBIT can be determined.
Assuming that having looked at a company’s income statement, the net income is $65,000, tax expense is $5,000, and Interest on loans is $3,000. These figures will be summed up to arrive at the company’s earnings before interest and taxes as follows:
EBIT = Net income + Taxes + Interest
EBIT = $65,000 + $5,000 + $3,000 = $73,000
Net income and EBIT similarities
- Both net income and EBIT are derived from the income statement.
- They are both used in calculating financial ratios which will further influence financial decisions. In essence, these figures give a glimpse of a company’s financial health. Through this, investors and other stockholders will be able to understand where the company is performing and where it is lacking.
- They both show a company’s earnings at different points in time.
Video: Comparison between EBIT vs Net income
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