In the previous, we used net profit to measure corporate performance. Although net profit has merits – it’s a powerful measure for thinking about how shareholders have been doing – it has problems.
First, it treats cash and non-cash expenses symmetrically.
Second, net profit also subtracts interest payments, which makes it hard to compare companies that finance themselves in different ways even though their operations could be quite similar.
Revenue similarly may need to be recognized over time. But this process of smoothing measures of performance is subjective, which allows managers to manipulate profits to their advantage. In contrast, cash is cash and, arguably, is not susceptible to similar levels of managerial discretion.
EBIT Equation:
EBIT = Net Profit + Interest + Taxes
As we saw, EBIT (or operating profit) gives a clearer view of how efficient and profitable a company is relative to net profit by not subtracting interest and taxes, which are not related to operational performance. EBIT still isn’t quite a measure of cash, however, because it is calculated after subtracting non-cash expenses such as depreciation and amortization.
For a fuller picture, finance professionals turn to EBITDA: earnings before interest, taxes, depreciation, and amortization.
EBITDA Equation:
EBITDA = Net Profit + Interest + Taxes + Depreciation and Amortization
Amazon’s Net Profit, EBIT, and EBITDA
Amazon provides a compelling example of the distinction between these three different measures. In 2014, Amazon’s net profit was −$241 million. Amazon’s EBIT, however, was $178 million, and the difference of $419 million represents taxes, interest, and currency adjustments. What about EBITDA? Because of a whopping $4.746 billion in depreciation and amortization, the EBITDA here is $4.924 billion—a far cry from the net loss of $278 million. So, Amazon generated lots of cash, as measured by EBITDA, but had losses according to profitability measures.
