Invested Credit

earnings-interestWhen looking at investments, there are two key metrics that analysts return to over and over again to define a company’s profitability. While both EBIT and EBITDA have been surrounded with controversy throughout their introduction to the capital markets, they continue to serve as an invaluable tool for understanding exactly how profitable a company is for shareholders, and what kind of impact both depreciation and interest expenses erode away the margins.

The Earnings Before Interest and Taxes metric was originally introduced to measure the amount of money that investors have a claim to before the fundamental costs of debt and tax are taken out. This is done to measure the operating profitability of the company. Understanding how it is that interest expenses represent the cost of leveraging the company, and taxes are imposed upon the company by outside powers, they do not so much reflect the benefits of operating decisions as they do the costs and implications of them.

As such, EBIT creates value for analysts in the way that it demonstrates the ability of management to create nominal returns through their decisions and actions. That being said, it does not take into account the expenses associated with those decisions, and should be taken in consideration against a comparison metric that does exactly such.

As EBIT gained popularity as a metric, a more aggressive variant began to gain similar exposure. The Earnings Before Interest, Taxes, Depreciation, and Amortization metric was at the height of its popularity during the late 80s and early 2000s (for reasons that will be discussed in greater detail in a later article), and took the concepts first introduced by EBIT to new extremes.

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Specifically, the EBITDA removes the aspects of Depreciation from its demonstration of income, so that it shows the tangible benefits that managers are creating for a company, without dilution from fixed amortization schedules. Essentially, we therefore have a picture of management’s ability to create earnings without regard for the costs or impacts of any of these decisions.

While certainly both are aggressive metrics, the benefits of using EBIT or EBITDA are obvious in the way that they simplify the task of determining what kind of revenue impact management is creating. As such, so long as either of these tools is combined with both common sense and a counter-metric for examining the expenses incurred by management’s actions, they remain some of the most useful equations in an analyst’s toolbox.