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EBIT and EBITDA

When a business owner is looking either for investment in their company or to put it up for sale on the open market, they may hear two different accounting terms for the very first time – EBIT and EBITDA.

In this article, TWP Accounting explains what these terms mean and why they are important. But first, let’s look at what an average financial statement for a UK business looks like…

Profit and Loss    
  Amount Letter
Revenue £2,000,000  
Costs of goods sold £500,000  
Gross profit £1,500,000  
     
Expenses    
Salaries £750,000  
Rent and other overheads £200,000  
Depreciation and amortisation £150,000  
Interest payments £100,000 I FOR INTEREST
Directors’ renumeration £100,000  
Total expenses £1,300,000  
     
Earnings before tax £200,000  
Corporation tax at 19% £38,000 T FOR TAX
     
Net earnings £162,000 E FOR EARNINGS

 

On all appearances, this is a healthy looking company. So how could we make it look even healthier to a potential investor or purchaser?

 

What is EBIT?

E for Earnings

The “E” is EBITDA is for earnings. Essentially, this is your company’s net profit as it reports it to HMRC. Net profit is the total of all of your sales revenue minus the sum of everything that can be legitimately counted as a business cost.

Your accountant’s job is to save you money on the amount of tax you pay. That means that we will include costs on your balance sheet that have nothing to do with your trading activities but more to do with what the value of what your business owns (assets) and the amount of money it owes (liabilities).

By doing this, we bring the amount of Corporation Tax your business pays down.

B for before

The “B” stands for “before”. The items we’re about to remove from your net profit calculation will change the size of your net profits and your assets in your favour. In other words, they’ll make your company look better from a buyer or investor’s perspective.

I for Interest

When a company is taken over, it is normally incumbent on the purchaser to settle a business’s outstanding debts. Although the purchaser may pay off the original owner’s old debt with new debt used to finance the purchase, one thing is for certain – that original debt won’t exist after takeover.

Our sample company, on its profit and loss account above, is paying £100,000 in interest. If we remove the interest, we’ll add that £100,000 back to the earnings meaning that the company’s net profit before interest is now £300,000 – a 50% increase.

T for tax

The “t” stands for “tax”. On an EBIT statement for our sample company, you’d add back the tax figure shown on the table above to the interest figure. Therefore, the value of “I” and “T” is the £38,000 corporation tax payment plus the £100,000 paid in interest – £138,000.

So net profit is £200,000 however EBIT is £338,000, a 69% increase.

What is EBITDA?

EBIT stands for Earnings before Interest and Tax

We know what EBIT stands for. What does EBITDA stand for and why is it important? We’ll tell you why towards the end of the article but, for now, let’s continue decoding the acronym.

Profit and Loss    
  Amount Letter
Revenue £2,000,000  
Costs of goods sold £500,000  
Gross profit £1,500,000  
     
Expenses    
Salaries £750,000  
Rent and other overheads £200,000  
Depreciation and amortisation £150,000 D & A
Interest payments £100,000 I FOR INTEREST
Directors’ renumeration £100,000  
Total expenses £1,300,000  
     
Earnings before tax £200,000  
Corporation tax at 19% £38,000 T FOR TAX
     
Net earnings £162,000 E FOR EARNINGS

D for Depreciation

D is for “depreciation”. Depreciation describes the fall in value of a physical asset that your business owns over time. Depreciation doesn’t actually remove any money from your business bank account – rather it reflects the decreasing amount that you could sell a used asset for.

When we’re doing your accounts for you, we calculate the depreciation in the value of your assets and add that to your expenses, the effect of which is to reduce your taxable profit.

There are two ways that we can calculate depreciation for you – in a straight line or using “reducing balance”. Let’s say that you need to buy a counter for your retail premises and it costs you £15,000. You expect to get 10 years of life out of it. This is how we could calculate it for you:

  • On a straight line depreciation, we divide that £15,000 by 10 and add that £1,500 to your expenses every year (saving you £285 in corporation tax).
  • On a reducing balance depreciation, we say that the value of the counter falls by 20% every year. In that instance, we would claim say that the value of the counter at the end of the first year is £12,000, the second year £9,600, the third £7,680, and so on. We would add the annual depreciation back to your expenses column.

A for Amortisation

A is for “amortisation” and it’s exactly the same as depreciation except that it refers to non-physical or intangible assets.

As with physical assets, intangible assets like goodwill and patents reduce over time.

Goodwill and patents both have a “useful life” – for example, the value of a patent on breakthrough medicine is at its highest when that patent prevents competitors from producing the same drug. However, once the patent has expired and other manufacturers can produce their own version, the value of that patent is greatly reduced, sometimes to zero.

Likewise a company customer data and goodwill. A database with 5,000 buyers from the previous year is much more valuable than another database with 10,000 buyers on from 15 years ago.

The effect of D and A

With EBIT, we saw how a net profit of £200,000 became £338,000. The depreciation and amortisation shown on our fictional company balance sheet is £100,000, so if we add the interest, tax, depreciation, and amortisation to the net profit, £200,000 becomes £438,000, an increase of 119%.

EBITDA can be calculated in two different ways – EBIT plus DA or E + A + D + T + I.

Words of warning with EBITDA

EBITDA may give an investor or a buyer a better idea of the underlying profitability of the trading activities of a business. EBITDA is unencumbered by the techniques legally and legitimately used by accountants by reduce net profit to minimise Corporation Tax payments.

EBITDA can be used by a potential investor or buyer to understand better the level of debt a company can be loaded with for the purchase itself and any subsequent investment into the growth of a newly acquired business.

Either at the point of sale or inward investment, a company’s worth (and the worth of its shares) may be determined by the financial performance of the business in a particular year applied to a multiple. If the multiple is 5 and the profit is £200,000, the business may be considered as being worth £1,000,000.

Because, in many cases, EBIT and EBITDA make a company look healthier than net profit, they’re often used by sellers as a negotiation tactic to increase the value of their company and its shares. A seller may insist that his or her company is worth 5 times EBITDA instead of 5 times net profit.

However, valuing a business is an inexact science and financial performance as expressed in net profit, EBIT, or EBITDA may only be one in a basketful of considerations about assigning an overall price to a company.

EBIT and EBITDA may also be used to disguise a company’s underlying trading losses by inflating costs and any business purchaser worth their salt will look deeper into a target company’s accounts as part of their due diligence anyway. It would pay you and your business broker to more carefully spin the prospects of your business under new ownership if it’s showing an EBIT or EBITDA profit but showing net losses every year.

Considering selling or investing?

TWP Accounting’s team are experienced business advisors and accountants with years of experience helping our clients to sell their businesses and to attract outside investment. Contact TWP Accounting on 01932 704 700 or email your accounting partner at service@twpaccounting.co.uk.

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