When assessing the financial performance of a corporation, there are numerous useful metrics you can examine. Two of the main ones are operating income, which is profit minus operating expenses; and earnings before interest, taxes, depreciation and amortization, more commonly referred to as EBITDA. Looking at both provides a more complete picture of a company’s financial performance and potential than either one alone. We’ll examine both metrics so you can understand how to use them to assess a company’s performance.
There are two ways to calculate EBITDA. One way starts with net income, also known as net profit. This is the proverbial “bottom line,” the last figure at the bottom of the income statement after all revenues and expenses are accounted for. It refers to a company’s earnings minus business and operating expenses.
Starting with net income, one gets to EBIDTA by adding back any expenses for interest, taxes, depreciation and amortization. Interest includes interest paid on loans. Taxes consist of any income or other taxes that the company paid during the period.
Depreciation is a non-cash item. It accounts for the loss in value over time of assets the company owns. Amortization, another non-cash item, is the amount loan balances are reduced as the company pays off its debts.
This EBITDA formula looks like this:
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
Another way to calculate EBITDA is by taking the figure for earnings before interest and taxes (EBIT) and adding back depreciation and amortization. EBIT is another widely used financial measure that adds expenses for interest and taxes back to net income.
This EBITDA formula looks like this:
EBITDA = EBIT + Depreciation + Amortization
As the formula shows, what makes EBITDA different from EBIT is that EBITDA adds back amounts for depreciation and amortization. Similarly, EBITDA differs from operating income because it adds back some expenses to the net income figure.
Calculating Operating Income
To figure operating income, subtract operating expenses from gross income. Gross income consists of all the company’s income minus the cost of goods sold (COGS). COGS includes materials, labor and other expenses directly related to producing the company’s goods and services.
The formula for operating income looks like this:
Operating income = Gross income – Operating Expenses
In addition to COGS, other operating expenses subtracted from net sales to get operating income include sales, general and administrative (SG&A) expenses. The expenses subtracted from net sales to figure operating income also include depreciation and amortization.
COGS and SG&A are cash expenses, meaning the company had to pay out money for them. Depreciation and amortization are non-cash expenses.
The operating income figure does not include paying interest and taxes. EBIT also adds back interest and tax payments to the net income figure. However, unlike operating income, EBIT includes non-operating income and non-operating expenses. A gain or loss on the sale of an asset is an example of a non-operating income or expense item that would be added back to net income to produce EBIT.
Uses for EBITDA
EBITDA is used to understand the earning power of a company’s operations, rather than the actual earnings from operations. Because it excludes costs for depreciation and amortization, EBITDA also can provide insights into a corporation’s cash flow that operating income does not. That knowledge helps you understand how well a company can handle its operating costs.
In addition, EBITDA is useful is that there are not always hard and fast rules about how to calculate depreciation. To remove the effects of decisions about how to figure depreciation, investors can look at EBITDA. This may provide a clearer picture of the company’s earning potential.
Investors may also use EBITDA to filter out effects of management manipulation of financial results. Depreciation, in particular, can be adjusted by company management to make profits look better.
Finally, EBITDA is useful for comparing the earning power of companies of various sizes, with different tax situations and different debt structures. While it’s widely used by investors and managers, EBITDA is not, however, an official measure under Generally Accepted Accounting Standards (GAAP). Operating income, on the other hand, is an official GAAP measure.
Uses for Operating Income
While EBITDA measures a company’s profit potential, operating income gives the actual profit generated by the company’s operations. Net income also gives an actual profit figure, of course, but it’s somewhat different from operating income.
Operating income differs from net income in that net income may include sources of income other than operations, such as interest income. Also, like EBITDA, operating income does not take into consideration expenses for interest and taxes. Net income does account for these expenses.
EBITDA and operating income are both useful metrics to analyze and compare a company’s financial performance. Each has advantages and limitations compared to the other. Together they can be used to get a more complete and accurate picture of a company’s profitability.
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