What is EBIT?
What is EBIT? Neil Ackroyd, discusses EBIT (Earnings Before Interest and Tax).
What is EBIT?
Neil Ackroyd is the Founder and principle interviewer at Corporate Finance TV.
Neil Ackroyd Welcome to Corporate Finance Television, my name is Neil Ackroyd. Today we’ll be giving you knowledge to choose by discussing business valuation in the context of asking for and receiving offers. So, when you get to the stage in your transaction when you’re looking to ask for offers for you business what messages should you be sending out and why and what should you be receiving back. So you want to send a consistent message to all of your potential purchases and whether that message is in the form of a process letter that specifically lays out exactly what you’re asking for and what you expect from every purchaser of the consistency or whether you’re actually just doing it on the telephone you still need to have straight in your mind exactly what you’re asking for, the reason you’re asking for it and then when you receive your offers how to use those to usefully compare and negotiate. So in thinking about what you’re going to offer people in terms of information and what you’re going to ask for in terms of offers you need to understand three terms. What is EBIT? What is cash free debt free? And what is a normalised level of working capital? So these three terms fit together quite neatly and what you’re offering people is you’re offering to sell them your business on a cash free debt free basis, with a normalised level of working capital and you’re offering them an earning stream that is earnings before interest and tax. So let’s drill down into all three of those terms so that we understand them fully. So what is EBIT? Well, EBIT is earnings before interest and taxation. And why are we giving people EBIT as a number? Well more accurately, adjusted EBIT as a number? Well, we’re giving it them because for a lot of profitable businesses, and there are exceptions like telecoms, reseller market, software and some biotechnology companies and numerous others but generally speaking people value businesses on a multiple of EBIT. So you’re telling them that I will sell you a future earnings stream, whether that’s £2 million, £4 million or £10 million, they’re buying the business and they’re valuing it on the expectation that the current profits stream will either remain or will increase. So what we’re saying is that the relevant earnings stream that we’re giving them is adjusted earnings before interest and tax. So it is essentially the operating profit of the business, the amount of money that the business generates from its asset base before you take off interest and before you allow for tax. And largely these two things are ignored because interest comes from cash or debt which we’re going to exclude from the transaction and taxation is different depending on the tax situation of each individual purchaser, so it’s just simpler to ignore it. Now the adjustments we talk about are taking out the items that won’t recur under the ownership of the new owner and they vary from force majeure or Acts of God, so things that happen in a particular year that just don’t recur like the effects of a customer going bankrupt that’s a one-off event or a huge redundancy programme because you were changing the strategy of the business all the way through to the simple old chestnut of the owner manager takes a lot of money out of the business far in excess of the market rate for the services that he provides. So you adjust for those and then it gives the purchaser a good idea of when I own this business it’s going to get £2, £4, £10 million whatever the number is, but that’s what I can expect to get in Year 1 and then they can make some assumptions about future growth. So, we’re using earnings before interest and tax, we’re giving that to the purchaser so that they can value that earnings stream.