A corporation's published financial statements – the income statement, balance sheet and cash flow statement – provide most of the primary information analysts and investors use to evaluate the company's performance, value and prospects. Interest expense, net income and earnings before interest and taxes (EBIT) can all be found on a company's income statement.
The Income Statement
As described by the Corporate Finance Institute, the income statement contains data about a company's revenues, expenses, net income and taxes. The top block reports gross margin, which is the difference between sales and cost of goods sold (COGS). Service companies replace COGS with the cost of services sold. Next come blocks for operating expenses, other income, interest and taxes.
The final figure is net income, which the company's CPA adds to the retained earnings account on the balance sheet at the end of the year. To verify the consistency of the data, it's important to know how an income statement works.
Definitions of Terms
One of the relationships found on a corporate income statement is:
EBIT = Net Income + Interest + Taxes
Brown University explains that EBIT represents a company's net earnings before subtracting interest expenses and taxes. Alternatively, it equals a company's gross margin minus its operating expenses.
EBIT is similar to operating profit in that both reflect a company's general and administrative expenses, including rent, advertising, depreciation, payroll taxes, property taxes, sales taxes, salaries and wages, supplies, travel and entertainment. However, you exclude nonoperating expenses and income from operating profit, such as proceeds from a lawsuit or loss from discontinued operations.
EBIT is a popular metric that helps analysts gauge a company's profitability from operating and nonoperating earnings for a given time period. It is not included in the metrics recognized under generally accepted accounting principles (GAAP).
What a corporation pays on debt, such as bonds, notes, lines of credit and equipment financing, is interest expense, which is a line item on the income statement. The rate of interest represents the cost of borrowing money and can consist of simple interest and/or compound interest on both short-term and long-term debt. Borrowing money can help a company increase production and sales, and interest is tax-deductible. Still, if the amount of interest payable is too high, it eats into the company's profits.
You can combine interest income and expenses into a total interest figure on the income statement or report them separately. This category includes the total amount of financing charges, such as capital lease payments and bond amortization. When subtracted from operating profit, the result is taxable income.
You can verify a yearly income statement's interest figure by multiplying each debt (listed in the balance sheet's long-term and current liabilities sections) by its corresponding annual interest rate (available in the corporate financial notes of the annual statement) and summing the products.
Taxes are the income taxes that a corporation must pay on its profits. It equals the taxable income multiplied by the company's tax rate. Taxes are stated directly on the income statement.
Net income is the company's after-tax profits (i.e., the bottom line on the income statement). Investors and analysts closely watch new announcements of net income to gauge how a company is doing and what its stock shares are worth.
Solving the EBIT Equation for Interest
You can rearrange the EBIT equation to solve the interest expense formula:
Interest = EBIT – Net Income – Taxes
The result should equal the interest expense calculated on the corporation's income statement for the period.
For example, suppose a company has EBIT of $10 million, net income of $7 million and taxes of $2 million. Interest would equal ($10M - $7M - $2M), or $1 million.
Many analysts prefer to follow EBIT rather than net income because some feel it is less prone to manipulation. For example, a company might increase net profit by temporarily paying down debt, thereby saving on interest expenses. Another tactic is to hold earnings offshore to avoid taxes. By concentrating on EBIT, analysts, managers and investors can better understand how core operations are performing.
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