EBIT (Operating Income): Meaning, Calculations, and Relevance in Valuation

EBIT (Operating Income) Definition: EBIT is a company’s Earnings Before Interest and Taxes, or Operating Income on the Income Statement (Gross Profit minus Operating Expenses), sometimes adjusted for non-recurring charges; it represents the company’s core, recurring business income before the impact of capital structure and taxes.

We say that EBIT is “before” interest and taxes because the Operating Income line appears above or “before” both these deductions on a company’s Income Statement:

EBIT is NOT adjusted for non-cash charges such as Depreciation & Amortization – it’s only adjusted for non-recurring charges, such as one-time write-downs or impairments that might affect it.

For a good example of this, consider Steel Dynamics’ historical Income Statement below:

EBIT is a key driver in financial models and sometimes acts as a proxy for Free Cash Flow, or Cash Flow from Operations minus Capital Expenditures.

This is because Free Cash Flow reflects a company’s re-investment in its business via the deduction for Capital Expenditures (CapEx), and EBIT indirectly reflects this same re-investment since it deducts Depreciation & Amortization, which represents the “after-effects” of CapEx in earlier years.

Different companies have different capital structures and tax rates, so EBIT helps investors normalize and compare companies based strictly on their business fundamentals.

For example, if Company A has a high Debt balance and Company B has minimal Debt, Company A will also have a much higher Interest Expense than Company B.

That Interest Expense will reduce Company A’s Net Income, and it might be significantly lower than Company B’s as a result.

But this is deceptive because it just means that Company A has chosen to finance its business differently from Company B; their day-to-day operations might be similar.

EBIT intentionally ignores these differences and compares Companies A and B strictly based on their core businesses.

EBIT (Operating Income): Files & Resources

You can get the Excel files and PDFs used in this tutorial below:

EBIT vs. EBITDA vs. Net Income (XL)

Steel Dynamics -10-K Filing (PDF)

Steel Dynamics – Income Statement (JPG)

How to Calculate EBIT (Operating Income)

Depending on the available information, you can calculate EBIT in several ways:

Calculation Method #1: Revenue – COGS – OpEx, or Gross Profit – OpEx

Here’s an example of this method for Steel Dynamics:

For 2022, EBIT = $22,260,774 – $16,142,943 – $545,621 – $452,551 – $27,738 = $5,091,822.

In other words, the company has earned $22 billion in revenue for the year and $5.1 billion in Operating Income, which is a margin of 23%.

This calculation method is pointless because the company explicitly states its Operating Income on its Income Statement, so we could just use that and skip these steps.

Calculation Method #2: Operating Income + Add Back Non-Recurring Charges That Have Reduced Operating Income

This method corresponds to the definition above: Take the stated Operating Income and “add back” non-recurring expenses that may have affected it:

For example, for 2020, EBIT = $847,142 + $19,409 = $866,551.

So, the company has earned $867 million on revenue of $9.6 billion, a margin of ~9%.

EBIT is slightly higher than the stated Operating Income because of the non-recurring charge for the Asset Impairment.

Calculation Method #3: Net Income + Taxes + Net Interest Expense + Non-Core Income/Expenses + Non-Recurring Charges

This method is not recommended because it creates a lot of unnecessary work.

Instead of starting with Revenue or Operating Income, you could start at the bottom of the Income Statement, with Net Income, and “adjust up” from there:

There’s no reason to use this method because all companies disclose Operating Income in their financial statements, and it’s much easier to start from there when calculating EBIT.

What Does EBIT (Operating Income) Mean?

As stated above, EBIT is sometimes viewed as a “proxy” for Free Cash Flow since they both reflect some degree of a company’s required re-investment in its business.

However, this is not completely accurate because EBIT is before Taxes, while FCF deducts the full Taxes.

FCF also deducts the company’s Net Interest Expense, while EBIT ignores it.

And FCF reflects the Change in Working Capital, while EBIT ignores it.

Therefore, while EBIT and Free Cash Flow are similar in some ways, there are also many differences, and it’s a stretch to say that EBIT is a “proxy” for FCF.

It’s more useful to think of EBIT as the “business profits available to pay different entities”: the shareholders (equity investors), the lenders (debt investors), and the government.

Here’s an example using Steel Dynamics once again:

If you look at a company’s EBIT, you can see at a glance how much it can “pay” the government (taxes), the lenders (interest), and the shareholders (potential dividends).

This can also alert you to potential problems with a company’s capital structure.

For example, if a company has an Interest Expense of $100, but its EBIT is only $80, it has a major problem because it cannot afford to pay its lenders with its pre-tax business profits.

But it could use some of its Cash balance, sell an asset, or cut spending to cover this expense.

But just by looking at EBIT and comparing it to the amounts owed to different investors and stakeholders, you can get a quick sense of the company’s financial viability.

EBIT (Operating Income) vs. EBITDA vs. Net Income

We have a detailed tutorial on EBIT vs. EBITDA vs. Net Income, so please refer to that for all the details.

The short version (excerpt from that article) is as follows:

At a high level, EBIT, EBITDA, and Net Income all measure a company’s profitability, but the definition of “profitability” varies.

EBIT (Earnings Before Interest and Taxes) is a proxy for core, recurring business profitability, before the impact of capital structure and taxes.

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a proxy for core, recurring business cash flow from operations, before the impact of capital structure and taxes.

And Net Income represents profit after taxes, the impact of capital structure (interest), AND non-core business activities.

All these metrics have their uses, but in real life at investment banks, EBIT and EBITDA are much more useful than Net Income when valuing and modeling companies.

EBIT (Operating Income) in Financial Models and Valuation

EBIT is a starting point for the Net Operating Profit After Taxes (NOPAT) and Unlevered Free Cash Flow (UFCF) calculations in a DCF model and comes up in virtually all financial models, from LBOs to M&A to credit.

You can also use it as a valuation multiple (Enterprise Value / EBIT), but this creates some issues for IFRS-based companies due to lease accounting (see the section below).

The key point in financial models is that your assumptions and drivers must be sound whenever you forecast EBIT.

So, for example, if you project that a company’s EBIT will increase from $100 to $110, why does that happen?

Is it because they sell 20 more units for $1 each and spend $10 to do so?

Is it because sales stay the same, but they cut expenses by $10?

If there are expense reductions, what drives them? Fewer employees? Reduced salaries? Better deals with suppliers?

You need answers to these questions before you present a financial model or use it to justify an investment decision.

EBIT (Operating Income) Under IFRS for International Companies

In 2019, companies began to record Operating Leases directly on their Balance Sheets under IFRS 16 (ASC 842 in the U.S.) via a “Right-of-Use Asset” on the Assets side and a “Lease Liability” on the Liabilities & Equity side.

Under U.S. GAAP, companies still list the Rental Expense for Operating Leases as a standard Operating Expense on their Income Statements.

But under IFRS, companies now split this Rental Expense into “Lease Interest” and “Lease Depreciation,” even though it is still a simple cash expense in real life.

As a result, under IFRS, EBIT deducts only part of the Operating Lease Expense – the Lease Depreciation – which makes it problematic to use in valuations.

When calculating a valuation multiple such as Enterprise Value / EBIT, if a Liability is counted within Enterprise Value, the denominator (EBIT) should exclude or add back the entire corresponding lease expense (see: how to calculate Enterprise Value).

But EBIT cannot do this because it only deducts part of the Lease Expense!

You could adjust for this by creating a metric like “EBITL” or “EBITD” that adds back the Lease Depreciation, or you could deduct the Lease Interest from EBIT.

Essentially, EBIT should exclude the entire Lease Expense or deduct the entire Lease Expense for consistency.

However, the simplest solution is to skip EBIT in valuation multiples, use Enterprise Value / EBITDA instead, and ensure that Enterprise Value includes the Lease Liability for non-U.S.-based companies.

Here’s a screenshot from our demo Excel file that shows the issues with EBIT under IFRS and how the treatment of Leases distorts things:

What is a “Good” or “Bad” EBIT (Operating Income) or EBIT Margin?

We get many questions to this effect, but there is no universal answer because it depends on the industry, maturity of the company, and the specific situation.

For example, large, mature software companies such as Microsoft and Oracle often have Operating Margins of 40% or more because they have high operating leverage.

In other words, Microsoft can create a software product once and sell millions of copies for low marginal costs, dramatically increasing its margins.

On the other hand, manufacturing companies have much lower Operating Margins because they must spend a lot on physical products: parts, inventory, raw materials, factories, etc.

Steel Dynamics, from the examples above, has Operating Margins between 10% and 20% in most years, and many of its competitors have similar numbers.

So, EBIT and EBIT margins are relative, and you must look at a relevant set of comparable public companies to decide whether the firm you’re analyzing has “good” or “bad” margins.

Even within the same industry, there’s some nuance.

For example, Salesforce and Oracle are both “software companies,” but Salesforce has much lower EBIT margins because it is a newer, higher-growth company.

It needs to spend more on sales, marketing, and employees to achieve that growth – which has translated into lower EBIT margins historically: