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When to Use EBIT To Evaluate Companies?

Earnings before interest or tax (EBIT) is a common measure of the performance of a company. It is calculated by adding tax and interest expense to the earnings. The reason that EBIT is sometimes used instead of just earnings is that interest and tax expense are variable in nature and comparing EBIT is often a better indicator of the company’s performance. Unfortunately, knowing when to use EBIT can be a tricky task.

Why does corporate tax fluctuate?

The amount of tax a company pays will have a direct impact on the eventual earnings of the company. However, corporate tax varies each year. Just like income tax, there are tax exemptions and rules that may cause a company to pay more or less tax in any given year.

As such, removing tax expense is often good practice when comparing a company’s recent performance with its past. For instance, we do not want a one-off tax exemption this year to overstate the performance of the company.

Why remove interest expense?

As with tax expense, interest expense also tend to fluctuate year-on-year. There are two main reasons for this – one is within the company’s control, and the other is not. First, the company’s debt load may have changed. Second, and outside of the company’s control, is the fact that interest rates may fluctuate each year. This can cause the company’s eventual earnings to vary each year.

Because of that, it is often useful to remove interest expense when comparing past performances. By eliminating interest and tax expense from the comparison, we can get a better picture of the operating performance of the company.

So, when exactly should you use EBIT?

This is where many investors, myself included, sometimes get confused. EBIT must only be used for companies that do not tend to have a fluctuating debt load. For instance, comparing a company’s EBIT performance over the years is useful only for a company that maintains the same debt load. On the flip side, we should not use EBIT to compare a company that has just taken substantially more debt this year.

EBIT is especially useful for companies that often report a variable tax rate each year. This often clouds the true operating performance of the company. EBIT is, therefore, useful in clearing the air in such cases.

Do not compare one company’s EBIT to another’s earnings

A key point to note is that EBIT, as we have discussed, is vastly different from earnings. We should never make the mistake of comparing EBIT with earnings. By doing so, we will sometimes draw wrong conclusions about a company or its valuation.

The Foolish bottom line

EBIT is another useful metric that investors can use to compare a company’s performance with its past and its competitors. However, as useful as it is, the EBIT does have its pitfalls. As investors, we need to be acutely aware of when and when not to use EBIT as a metric.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Jeremy Chia doesn’t own shares in any companies mentioned.