Everyone needs to understand why profit is measured in different ways.
Some years ago, when I was attending an academic conference at a regional university, I decided to visit their bookstore during a break in the proceedings.
To my surprise, in the section of the store selling baseball caps and sweatshirts with the college name and logo, I spotted a pile of T-shirts that read: “I Love EBIT!” (accompanied by a red heart). I had a good chuckle about what I supposed was a neat in-joke for the school’s business majors. Granted, earnings before interest and taxes (also called operating profit or operating income) is a familiar acronym to finance students and professionals alike. But my experience indicates that this very important financial measure often needs to be clarified and explained to non-financial managers and professionals. The same goes for a related term EBITDA.
There are three basic measures of profit: gross, operating and net. Gross profit is revenue minus costs. Operating profit is revenue minus costs minus expenses. Net profit is revenue minus costs minus expenses minus interest and taxes. In financial reporting and analysis, ‘earnings’, ‘profit’ and ‘income’ are often used interchangeably. Therefore, what is EBIT or earnings before subtracting interest and taxes? Right! It is none other than operating profit or operating income. So why do finance and accounting professionals confuse non-financial people by throwing in another term and its accompanying acronym? I don’t know. But I do know that if non-financial people are confused by the interchangeable use of these terms, they might also be confused about the crucial issue behind them: what companies and their people need to do to improve these metrics.
An acronym related to EBIT, namely EBITDA, can be even more of a mystery to non-financial managers and professionals. EBITDA stands for earnings before interest, taxes, depreciation and amortization. Because both depreciation and amortization are non-cash expenditures, EBITDA is a simple measure of a company’s operating cash flow.
For the senior leaders of a company that uses EBIT or EBITDA as a key measure of performance, it is important to ensure that their employees at least understand the meaning of these terms. Otherwise it maybe not be easy for them to understand how and why they can make an impact on these measures. For example, if the financial goal is an improvement in a company’s EBIT margin (sometimes referred to as margin expansion) then their employees should be ready to do what is needed to control all costs and expenses while revenue is increasing. If a company chooses EBITDA rather than EBIT, then their employees should focus on variable costs and expenses rather than on the fixed costs and expenses in the form of depreciation and amortization.
Here’s another variation to the EBIT acronym that I came across in a recent client engagement: this particular client uses EBITA, or earnings before interest, taxes, and amortization, as a measure of its business units’ performance. Depreciation is the accrued (non-cash) cost of using of tangible assets, such as plant and equipment. Amortization is the accrued cost of using intangible assets, such as software and intellectual property. The client that uses this measure of performance has a lot of tangible assets and also has a lot of intangible assets because of some major acquisitions. Because amortization is an expense stemming from corporate-level decisions, the company decided to exclude it in the measure of the daily operating performance of their business units.
Financial leaders have a plethora of options at their fingertips, yet their aim must be to choose a measure that best reflects the goals of the business. That done, they must ensure that non-financial teams understand the term you choose. If they don’t, they are unlikely to grasp the goals of the business either.
– Phil Young PhD is an MBA professor and corporate education consultant and instructor