Indicator about profitability on equity investment

The purpose of this page is to explain the indicator about profitability among the indicators used in the analysis of companies and stocks.


Earnings Before Interest and Taxes (EBIT)

Earnings Before Interest and Taxes (EBIT) is, as the word says, income before paying any interest and taxes. EBIT is a concept similar to international operating profit expressed by the following formula. ref 1

EBIT = Net income + Interest expenses − Interest income + Income taxes

However, since net income includes artificial gains and losses such as income taxes-deferred in addition to income taxes-current, rewriting the above formula as the following formula makes it more simple. The amount of each term on the right side of the formula below are described in the income statement, and interest expense and interest income are included in non-operating income.

EBIT = Net income before taxes + Interest expenses − Interest income

In IFRS, items other than financial transactions such as interest and dividend income, interest expenses are included in operating income, so the above EBIT represents the concept close to operating income that is considered internationally.
The difference between EBIT and operating income under IFRS is that EBIT includes financial profit and loss which is excluded interest income and interest expense.
EBIT is income that excludes interest expense and interest income from net income before taxes, and operating income under IFRS is income that excludes financial income and financial expenses from net income before taxes.

In IFRS, profit / loss is classified into operating income / loss and financial profit / loss, while in Japanese GAAP, it is classified into operating income / loss, non-operating profit / loss, and extraordinary gain / loss.
Therefore, it should be noted that the concept of operating income differs depending on the accounting standard.
For a major portion of profit and loss, EBIT includes the same accounts as operating income based on IFRS or US GAAP, but does not necessarily include the same accounts as operating income without extraordinary gains and losses based on Japanese GAAP.

In a simpler explanation, EBIT is the total amount of accounts used in the process of calculating net income before taxes, ignoring only interest income and interest expenses.
In other words, if interest income is added to EBIT and then excluded interest expenses, net income before taxes is obtained.

Net income before taxes = EBIT + Interest income − Interest expenses

An overview of EBIT in Japanese income statement is shown in 2-5-1 (e).

Figure 2-5-1 (e) Explanatory picture of EBIT in Japan's income statement

Interest rates, tax systems, and accounting standards differ from country to country.
EBIT, which eliminates these effects, is used as an indicator to compare the profitability of companies internationally.

By the way, there is also a formula for calculating EBIT based on ordinary income and operating income.
However, this website does not adopt them for the following reasons.
・Ordinary income is inappropriate for use in the formula for calculating EBIT, because it is a profit specific to Japanese GAAP and is not recorded in income statements other than Jpan.
・It is inappropriate to use operating profit in the formula for calculating EBIT for the purpose of comparing companies internationally, because the profit included in operating profit differs from country to country.

There is also a formula that does not include interest income as interest, but this website does not use it for the following reasons.
・Whether to exclude interest income from the calculation of EBIT should be considered when interest income is a component of operating income related to main business.
・Interest income stated in non-operating income is interpreted as income from other than the main business.

Calculation example of Earnings Before Interest and Taxes (EBIT)

In the income statement based on Japanese GAAP, all accounts used to calculate EBIT are listed.
Here, an example of EBIT calculation is shown using the following income statement based on Japanese GAAP.
The unit of the amount is 1 billion yen.

Income statement (Japanese GAAP)
   Net sales
   ・・・
   Operating income
   Non-operating income
      Interest income 3
      ・・・
   Non-operating expenses
      Interest expenses 2
      ・・・
   Income before income taxes 151
   ・・・
   Net income
   ・・・

As explained above, EBIT is the total amount of accounts used in the process of calculating net income before taxes, ignoring only interest income and interest expenses.
Therefore, EBIT can be obtained by adding the interest expenses to the net income before taxes and then subtracting the interest income.
In this website, net income before tax is described as net income before taxes, but in Japan it is often described as income before income taxes.

\[ \textsf{EBIT}\ =\ 151 + 2 - 3\ =\ 150 \quad \]

With a unit, the EBIT in the above income statement example is 150 billion yen.

Since EBIT is an indicator that compares the earnings of international companies, not only Japanese GAAP but also an example of calculating EBIT under IFRS will be shown.

In IFRS, the format of the income statement differs depending on the company.
Here, an example of EBIT calculation is shown using the following general IFRS income statement. The unit of the amount is 1 billion yen.

Income statement (IFRS)
   Income statement
   ・・・
   (Operatin profit)
   Finance Income (Costs)
      Interest income 20
      Dividend income
      Interest expense 40
      ・・・
   Profit befor tax 930
   ・・・
   Profit for the year
   ・・・

Under IFRS, if interest income and interest expense are clearly stated in the income statement, EBIT can be calculated as follows.

\[ \textsf{EBIT}\ =\ 930 + 40 - 20\ =\ 950 \quad \]

With a unit, the EBIT in the above income statement example is 950 billion yen.

However, since the format of the income statement based on IFRS differs depending on the company, the method of obtaining the amount required for the calculation is not only one pattern.

For example, there are cases where the breakdown of financial income and expenses is not described and EBIT cannot be calculated from the income statement alone.
In such cases, it is necessary to check the items related to interest income and interest expense on the cash flow statement.
If the cash flow statement same format based on Japanese GAAP, EBIT can be calculated using the interest income and interest expenses listed above the subtotal column of the operating CF.

However, even in the cash flow statement, if interest income and dividend income have been described as a set such as "interest and dividend income", the amount of interest income alone is not known.
In such cases, searching for words such as "interest" or "finance income" in securities reports or financial statements may show a breakdown of finance income.

In addition, for companies that have adopted IFRS, there are cases where the calculation of the cash flow statement starts with net income after taxes instead of net income before taxes.
In the cash flow statement that starts with net income after taxes, interest expense and interest income may include not only profits and losses in one fiscal year, but also profits and losses in different fiscal years.
In such cases, if the breakdown of financial income is not stated in the securities report or earnings report, it is difficult for the average investors to calculate EBIT accurately.

If it is difficult to calculate EBIT, although it is not always accurate, it is better to calculate using the interest expense and interest income stated in the cash flow statement as it is, or to consider net income before taxes as EBIT.
This is because interest expense and interest income are usually smaller than net income before taxes, so there is not much error.
Although it takes costs, there is also a way to contact the IR of the company directly.

On the other hand, there are companies that clearly state EBIT in their income statements.

Earnings Before Interest Taxes Depreciation and Amortization (EBITDA)

Earnings before interest taxes depreciation and amortization (EBITDA) is the indicator that depreciation and amortization is added to EBIT.

EBITDA can be calculated by the following formula.

EBITDA = EBIT + Depreciation + Amortization

Depreciation is the devided cost for tangible fixed assets.
Amortization is the devided cost for intangible fixed assets.

In calculating EBITDA, there is diversity in the interpretation of "Interest" and "Depreciation and Amortization."
This website calculates EBIT using the following formula, which excludes interest income from earnings. ref 2 ref 3

EBIT = Net income before taxes + Interest expenses − Interest income

In IFRS cash flow statements, they are often listed as the item named "Depreciation and amortization" which is a combination of depreciation and amortization.
Therefore, it is easy to find the amount of Depreciation and Amortization from the financial statements based on IFRS.

On the other hand, in the cash flow statement based on Japanese GAAP, depreciation are specified, but the item named simply "amortization" often does not appear.
Instead of amortization, an item that often appears in the cash flow statement based on Japanese GAAP is "Amortization of goodwill".

This difference is due to the fact that Japanese GAAP allows amortization of goodwill, but IFRS does not.
And, in the case of Japanese GAAP, if the amortization of goodwill is stated in the cash flow statement, the amortization of goodwill is used in the calculation of EBITDA, as shown in the following formula.

EBITDA = EBIT + Depreciation + Amortization of goodwill

Amortization of goodwill, which is not permitted under IFRS, is taken into account in EBITDA under Japanese GAAP for the following reasons.
The fact that goodwill amortization is not permitted under IFRS means that the same company's EBIT will be higher under IFRS than it is under Japanese GAAP by the amount of amortization.
Therefore, under Japanese GAAP, if this amount is not added, different EBITDA will be given depending on the accounting standards, which is inconsistent.

As will be described later, EBITDA is an indicator that measures the cash profitability of the company.

Since the amortization of goodwill is not allowed under IFRS, the cash profitability of the company applying IFRS is included in the accounting profit EBIT.
On the other hand, the company applying Japanese GAAP show lower EBIT by the amount of amortization of goodwill than the company applying IFRS.
Therefore, using the amortization of goodwill as amortization in the calculation of EBITDA makes it possible to compare Japanese companies and overseas companies in terms of cash profitability.

In addition, the cash flow statement based on Japanese GAAP may not include an item correspond to amortization.
In this case, there is no amortization in the first place, so there is no need to count amortization.
Therefore, the EBITDA formula can be written as follows.

EBITDA = EBIT + Depreciation

Figure 2-5-1 (f) shows a conceptual picture of EBITDA in the income statement based on Japanese GAAP.
EBIT is earnings before taxes excluding income and expenses related to interest.
And depreciation and amortization do not accompany cash outflow, although they are a factor pushing down earnings.
Taht is, EBIT indicates earnings as accounting profit, while EBITDA indicates earnings as cash.

Figure 2-5-1 (f) Explanatory picture of EBITDA in Japan's income statement

Internationally, EBIT is a concept close to operating income, while EBITDA is a concept close to operating cash flow.
Therefore, EBITDA can be considered to be an indicator for valuing the profitability of a company from the perspective of cash flow.

In addition to interest rates and tax systems, depreciation and amortization ways for fixed assets also differ depending on the accounting standards of each country.
Therefore, it is not possible to compare companies internationally by profit after depreciation and amortization such as operating income, ordinary income, net income.
And, companis with a large depreciation have a large cash inflow compared to its EBIT, so EBIT cannot evaluate the cash profitability of such companies.

Therefore, EBITDA can be used to compare the cash profitability between international companies.

Calculation example of Earnings Before Interest Taxes Depreciation and Amortization (EBITDA)

The accounts used to calculate EBITDA are listed in the income statement and cash flow statement.
Here, an example of EBITDA calculation is shown using following income statement and cash flow statement, based on Japanese GAAP.
The unit of the amount is 1 billion yen.

Income statement (Japanese GAAP)
   Net sales
   ・・・
   Operating income
   Non-operating income
      Interest income 2
      ・・・
   Non-operating expenses
      Interest expenses 5
      ・・・
   Income before income taxes 217
   ・・・
   Net income
   ・・・
Cash flow statement (Japanese GAAP)
   Cash flows from operating activities
      Income before income taxes 217
      Depreciation 95
      Amortization of goodwill 15
      ・・・
      Interest income 2
      Interest expenses 5
      ・・・
      Subtotal
      ・・・
      Net cash provided by operating activities
      ・・・

As explained above, EBITDA is the indicator that depreciation and amortization have been added to EBIT.
First, the EBIT is calculated from the income statement as follows.

\[ \textsf{EBIT}\ =\ 217 + 5 - 2\ =\ 220 \quad \]

Therefore, EBITDA can be calculated as follows.

\[ \textsf{EBITDA}\ =\ 220 + 95 + 15\ =\ 330 \quad \]

With a unit, the EBITDA of the above company will be 330 billion yen.

In this example, the amount of interest expense and interest income on the income statement has been listed above the subtotal column on the cash flow statement.
Therefore, EBITDA can be calculated using only the cash flow statement.
But, in some cases, interest income and dividend income are listed together as "Interest and dividend income" in the cash flow statement.
In such cases, you need to check the income statement to calculate EBIT.

In addition, cash flow statements often do not include amortization such as amortization of goodwill.
In such a case, there is no amortization, so only depreciation needs to be considered.

In IFRS, Depreciation and amortization is often referred to as "Depreciation and amortization" together.
Therefore, if there are no other amortization to consider, simply add that amount of "Depreciation and amortization" to EBIT.

Net Operating Profit after Tax (NOPAT)

Net operating profit after tax (NOPAT) is defined by the following formula.
The effective tax rate is usually used as the tax rate.

NOPAT = EBIT × (1 − Tax Rate)

EBIT represents net income before taxes excluding net interest income only.
NOPAT, which is EBIT minus the tax rate, can be interpreted as net income obtained from other than net interest income.

Internationally, net income before taxes consists of operating income and financial balance, so EBIT is a concept close to operating income.
NOPAT is translated as net "operating profit" after tax because tax is excluded from that EBIT.
However, it should be noted that the operating profit mentioned here is different from the operating income of the Japanese standard.

Calculation example of Net Operating Profit after Tax (NOPAT)

NOPAT is EBIT after tax.

Here, an example of NOPAT calculation is shown using the following income statement based on Japanese GAAP.
The unit of the amount is 1 billion yen.

Income statement (Japanese GAAP)
   Net sales
   ・・・
   Operating income
   Non-operating income
      Interest income 1
      ・・・
   Non-operating expenses
      Interest expenses 20
      ・・・
   Income before income taxes 131
   ・・・
   Net income
   ・・・

EBIT is the total amount of accounts used in the process of calculating net income before taxes, ignoring only interest income and interest expenses.
Therefore, EBIT can be obtained by adding the interest expenses to the net income before taxes and then subtracting the interest income.

\[ \textsf{EBIT}\ =\ 131 + 20 - 1\ =\ 150 \quad \]

Therefore, if 30% is used as the effective tax rate, NOPAT can be calculated as follows.

\[ \textsf{NOPAT}\ =\ 150\ ×\ (1 - 0.30)\ =\ 105 \quad \]

With a unit, the NOPAT of this company will be 105 billion yen.

Free Cash Flow (FCF)

Free cash flow (FCF) is an indicator to measure the cash profitability of the company.

Simply put, FCF is the cash surplus after subtracting outflows from inflows, of cash.
To investors, it is considered as a surplus that can be distributed to shareholders or invested in the company's growth at the company's discretion.

FCF is a familiar term for investors, but in fact, the exact calculation method is not established.
Therefore, there is some arbitrariness in how the FCF is calculated. ref 4
In general, (NOPAT + depreciation) or operating cash flow is used as cash inflow.
On the other hand, as cash outflow, in addition to capital investment or investing CF, change in working capital, expences of interest, etc. are taken into consideration.

Regardless of what kind of calculation method is appropriate, a certain calculation method is necessary for investers.
Therefore, this website explains FCF using the following formula.

FCF = NOPAT + Depreciation − Capital investment − ΔWC

In additon, even if this formula is used, there is some arbitrariness in how to calculate the working capital.
Therefore, This website will use the following formula for calculating Working capital.

WC = Trade Receivables + Inventories − Trade Payables

The sum of the first and second terms on the right side n the formula represents the cash flow obtained from the business activities.

Capital investment of 3rd term on the right side in the formula is the investment amount in tangible and intangible fixed assets.
Capital investment is an ongoing expenditure that is determined by management to be necessary for the development and continuation of business.
Capital investment is described in [Summary of capital investment, etc.] in the securities report.
[Summary of capital investment, etc.] is written [設備投資等の概要] in the Japanese securities report.

ΔWC of 4th term on the right side in the formula is the change in working capital between the previous term and the current term, which represents the increase amount of money required for business operations.
In other words, it means that the amount of cash that companies can freely handle has decreased.

FCF is an important indicator in investment that is used to approximate the enterprise value of a company.
However, as mentioned above, since the calculation method is arbitrary, it is necessary for those who use FCF to calculate it by a certain method.

Calculation example of Free Cash Flow (FCF)

Here, an example of the calculation of FCF is shown using the following balance sheets, income statement, and cash flow statement.
The unit of financial statements is 1 billion yen.
In addition, it is assumed that there is a description that capital investment of 100 billion yen was implemented in the [Summary of capital investment, etc.] in the securities report.

Balance sheets (Japanese GAAP)
At end of previous period At end of current period
Assets
   Current assets
      ・・・
      Notes and accounts receivable-trade 350
      ・・・
      Merchandise and finished goods 200
      Work in process 150
      Raw materials and supplies 100
      ・・・
      Total current assets
      ・・・
Assets
   Current assets
      ・・・
      Notes and accounts receivable-trade 450
      ・・・
      Merchandise and finished goods 220
      Work in process 170
      Raw materials and supplies 110
      ・・・
      Total current assets
      ・・・
Total assets Total assets
Liabilities
   Current Liabilities
      Notes and accounts payable-trade 140
      ・・・
      Total current liabilities
      ・・・
Total liabilities
Net assets
      ・・・
   Total net assets
Liabilities
   Current Liabilities
      Notes and accounts payable-trade 210
      ・・・
      Total current liabilities
      ・・・
Total liabilities
Net assets
      ・・・
   Total net assets
Total liabilities and net assets Total liabilities and net assets
Income statement (Japanese GAAP)
   Net sales
   ・・・
   Operating income
   Non-operating income
      Interest income 2
      ・・・
   Non-operating expenses
      Interest expenses 5
      ・・・
   Income before income taxes 197
   ・・・
   Net income
   ・・・
Cash flow statement (Japanese GAAP)
   Cash flows from operating activities
      Income before income taxes 197
      Depreciation 110
      Amortization of goodwill 20
      ・・・
      Interest income 2
      Interest expenses 5
      ・・・
      Subtotal
      ・・・
      Net cash provided by operating activities
      ・・・

In order to calculate FCF, NOPAT, depreciation, capital investment, and change in working capital (ΔWC) are required.
First, NOPAT is obtained from the income statement or cash flow statement using an effective tax rate of 30%.

\[ \textsf{NOPAT}\ =\ (197 + 5 - 2)\ ×\ (1 - 0.30)\ =\ 140 \quad \]

Next, calculate ΔWC from the balance sheets of the previous term and the current term.

\[ \textsf{WC of the current term}\ =\ 450 + (220 + 170 + 110) - 210\ =\ 740 \quad \] \[ \textsf{WC of the previous term}\ =\ 350 + (200 + 150 + 100) - 140\ =\ 660 \quad \] \[ \textsf{ΔWC}\ =\ 740 - 660\ =\ 80 \quad \]

Therefore, FCF can be calculated as follows.

\[ \textsf{FCF}\ =\ 140 + 110 - 100 - 80 =\ 70 \quad \]

With a unit, FCF in this example is 70 billion yen.

FCF is a cash that companies can freely use, such as repayment of borrowings, investment in growth, dividends and share buybacks.
It should be noted that the more FCFs there are, the higher the business value, but since the cash obtained is worthless unless it is used, it is also important for shareholders how the company uses the cash.

Reference

  1. 1)   “INTM515020 - Thin capitalisation: practical guidance: measuring earnings: earnings before interest and tax (EBIT).” Website of Gov.uk.
  2. 2)   "EBITDA (Earnings before interest, tax, depreciation and amortisation)" Website of IFRS Foundation.
  3. 3)   "BEGIN PRIVACY-ENHANCED MESSAGE" Website of SECURITIES AND EXCHANGE COMMISSION.
  4. 4)   Bhandari, PhD, S. B., & Adams, PhD, CPA, M. T. “On the Definition, Measurement, and Use of the Free Cash Flow Concept in Financial Reporting and Analysis: A Review and Recommendations.” Journal of Accounting and Finance, vol. 17, no.1, 2017. Retrieved from https://articlegateway.com/index.php/JAF/article/view/972
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