EBIT EPS ANALYSIS

 

Basics of EBIT-EPS Approach

It is important to understand what EBIT and EPS mean to understand what the analysis is meant to be.

  • EBIT refers to earnings before interest and tax. The metric makes interest and taxes irrelevant. Therefore, an investor can understand how the company is performing out of the balance sheet’s composition which essentially makes interest and taxes the focal point of consideration. In terms of EBIT, there is no difference if a company has huge debt or no debt at all. The repercussions will be the same.

  • EPS or earnings per share is the metric that shows a company’s earnings including interests and taxes. It is an important metric because it shows the earnings on a per-share basis which helps the investors understand how a company performs on an overall basis. If a company’s overall profit soars high but the payment to investors is low, it is a bad gesture for investors owning a fixed number of shares. EPS shows this dynamic rule simply and in a clear manner.

The ratio between these two metrics can show how the bottomline results, the company’s EPS, are related to its performance irrespective of its capital structure, the EBIT.

Limitations of EBIT-EPS Analysis

Although EBIT-EPS analysis is a good way to check the earning sensitivity of a company, it has certain limitations too.

No Consideration of Risk 

The EBIT-EPS analysis does not consider the risk associated with a business project. It simply shows whether the earnings are enough for a corporation. It is not needed in case of a profit larger than returns, but it can be hurting if the opposite situation is there. When the profits are low, but the interest is high, then businesses may be in turmoil.

Contradictory Results

When new equity shares are not considered in a different alternative financial plan, the results arising out of this can get erroneous. The comparison of plans also becomes difficult when the number of alternatives increases.

Over-capitalization of Funds

This analysis ignores the over-capitalization of the funds. Beyond a certain point, additional capital should not be employed to generate a return in excess of the payments that should be made for its use. The analysis does not address such cases.


Explain Earnings before interest and tax (EBIT) – Earnings per share (EPS) approach in capital structure.

Before going for Earnings before interest and tax (EBIT) – Earnings per share (EPS) approach, let us discuss briefly about EBIT and EPS.

With the help of Earnings before interest and tax (EBIT), investors and managers can analyse company’s performance without considering balance sheet.

With the help of Earnings per share (EPS), investors can measure profit-earning ability of a company and investors will calculate the returns for their shares.

EBIT – EPS approach determines optimal capital structure having high EPS for a given EBIT. It also determines best debt and equity ratio that used to finance the business. It examines effect of financial leverage by observing EPS with different levels of EBIT.

Formula

            (EBIT – In(a)) (1-T) – Pd(a) / OSa = (EBIT – In(b)) (1-T) – Pd(b)) / OSb

L.H.S.

EBIT = Earnings before interest and tax, In(a) = Interest in plan A, T = corporate income tax,

Pd(a) = preference dividends in plan A, OSa = total number of outstanding stock in plan A

R.H.S.

EBIT = Earnings before interest and tax, In(b) = Interest in plan B, T = corporate income tax,

Pd(b) = preference dividends in plan B, OSb = total number of outstanding stock in plan B

Advantages of this approach are −

  • Best financial plan can be selected.
  • With the help of this approach, we can compare between company, specific products, departments etc.
  • Capital structure can be determined to obtain maximum EPS.
  • Performances of various sources can be evaluated.

Disadvantages of this approach are −

  • Risk is not considered.
  • Complex to calculate.
  • No limitations for source of financing.
  • Determination of over capitalisation is difficult.

What is earnings before interest and tax (EBIT)?

Sometimes EBIT is the amount which deducts all operating expenses from sales revenue, which is called operating income. EBIT is the amount generated in a particular accounting period.

Formulas

  • bases on TR, CGS, OE
    • EBIT = TR-CGS-OE

Here, TR = Total Revenue, CGS = Cost of Goods Sold, OE = Operating Expense

  • bases on NI, In, Ta
    • EBIT = NI+In+Ta

Here, NI = Net Income, In = interest and Ta = taxes

  • EBIT tells amount money earned by a company from its operations.
  • Investors can compare different tax situations using EBIT.
  • Investors can compare different companies with in sector

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