The language of finance can be intimidating to non-finance people and yet it is imperative to understand the basics if you want to communicate with authority within the business world. Acronyms abound but understanding what they mean and crucially, why they matter, will take the sting out of the tail of otherwise incomprehensible reports and accounts and allow you to make better and well-informed decisions about your business strategy.
PBIT is profit before interest and tax. EBITDA stands for earnings before interest, tax, depreciation and amortisation. But what do they tell us?
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Profit is the difference between a company’s sales, or ‘revenues’, and its costs. It is clearly preferable to make a profit (sales more than costs) than a loss. At the top of any profit and loss account (or income statement) is the sales figure. This is one of the most important figures in a set of accounts. Beneath the sales figure there is the cost of sales figure. These are costs that vary with sales.
Deducting these costs from sales gives the gross profit figure. So if sales are £1m and the cost of sales is £750,000, then the gross profit is £250,000.
Gross profit is calculated before overheads, or indirect costs, which do not vary with sales. These include the costs of property and full-time staff. Gross profit less operating costs is operating profit. This is also known as profit before interest and tax (PBIT) or earnings before interest and tax (EBIT). PBIT is frequently used by creditors to measure a company’s earning and paying capacity.
The main issue for analysts with the operating profit figure is that it is stated after depreciation and amortisation. These numbers are particularly subjective and therefore may be prone to ‘creative accounting’ and manipulation.
Analysts, therefore, often prefer EBITDA ie, earnings before interest, tax, depreciation and amortisation. Depreciation and amortisation are unique expenses that are non-cash and expenses related to assets that have already been purchased.
Depreciation is calculated by taking the capital cost of a longterm asset and spreading the cost over its useful life. The aim is to match the cost to the period of benefit. For example, if you buy a machine for £10,000 and plan to use it for five years before disposing of it for nil proceeds, on average the cost each year will be £2,000 (i.e. £10,000 / 5). That is the principle of depreciation. It is an accounting estimate as someone needs to make a judgement on the life of the asset or possible proceeds from disposal. If the same principle is applied to intangible assets (such as patents, licences or brands) it is known as ‘amortisation’.
They are subject to judgment or estimates — the charges are based on how long the underlying assets are projected to last, and are adjusted based on experience, projections, or, as some would argue, fraud.
The idea of using earnings before depreciation and amortisation is that it eliminates these subjective estimates.