What profitability metrics are you using in your S&OP/ IBP? Many companies have adopted EBITDA but is it the right metric to use? What about traditional metrics including Operating Profit?
In this article, we are going to cover the following:
- What are profitability metrics?
- What’s Operating Profit?
- What’s EBIT?
- What’s EBITDA?
- Which profitability metric is best to use in S&OP/ IBP?
Profitability Metrics Do Not Measure Cash
Profits are not cash. Because of this, profitability metrics do not measure cash; they measure profits. To understand the difference between profit and cash, we want to know about accrual and cash accounting.
The difference between accrual and cash accounting is timing. Cash accounting tracks the in-flows and out-flows of funds from revenues and expenses.
It follows the money trail. Where money goes—in and out of the business—there is cash accounting to record. For example, payments to raw material suppliers and payments from customers.
Accrual accounting tracks the actions that generate revenues or incur expenses, keeping aside when funds flow inside or outside of the business.
For example, when the business ships products to customers, accrual accounting records that transaction, as the company expects to receive a payment. It doesn’t matter if the customer will pay in 30 or 60 days, “the fact” or shipment that generates the future payment took place.
The same applies to purchases from suppliers. When the company receives the material, accrual accounting records such a transaction to reflect the future payment that could be in 60 or 90 days.
Per cash accounting, if funds don’t exchange ownership, there are no transactions to record. Measuring profitability involves following accrual accounting.
Operating Profit
Operating profit — also called operating income — is in the Profit and Loss Statement (P&L) or Income Statement—a core financial statement that follows accrual accounting.
Operating Profit is recognized by the generally accepted accounting principles (GAAP). This means that this metric is part of the standardized set of principles that public companies in the US must obey.
I have listed below the steps for the operating profit calculation:
- Step 1: Take the gross profit. This is the difference between revenue and COGS (cost of goods sold). COGS is all costs incurred to get the company’s products available to sell.
- Step 2: Deduct operating expenses (OpEx). OpEx are all costs to support production including general and administrative, marketing, rent, and utilities, among others.
- Step 3: Deduct depreciation and amortization. Depreciation and amortization are non-cash items. Depreciation is a reduction in the value of an asset like Property, Plant, and Equipment (PPE), due to wear and tear. Amortization is the same as depreciation but applied to intangible assets.
Operating Income or Operating Profit = Revenue – Cost of Goods Sold – Operating Expenses – Depreciation – Amortization
Operating profit shows the net earnings from the core business. The focus is on performance. It’s important to note that operating profit considers all the expenses that are necessary to run the business, including depreciation and amortization.
A positive operating profit means that the company is performing. A negative result from operations means that costs are higher than revenues.
Operating profit leaves aside the financial aspects. For example, Revlon had a positive operating profit in 2021 of $103.2 in millions.
When taking into account the financial aspects, the company had a negative loss before taxes of $200.7 in millions. Interest expense turned operating profit into a significant loss and the company ended up filing for bankruptcy.
EBIT
EBIT stands for earnings before interest and taxes. Like operating profit, the focus of EBIT is excluding the financial aspects. Many times, confused with operating profit, EBIT also includes non-operating net income.
Non-operating income comes from non-core activities. For example, the company may receive dividends from investments in other companies.
These dividends are non-operating income. Another example is the proceeds from selling a machine. EBIT also considers non-operating expenses such as a loss on asset disposition and a lawsuit.
Unlike operating profit, EBIT is a non-GAAP metric. EBIT measures company’s profitability as a whole, covering the core-business operations and business-related expenses.
Operating profit limits profitability to that coming from the core business only. EBIT calculation is off the P&L. It is right before getting to the financial aspects.
The calculation consists of adding net non-operating profit to operating profit.
EBIT = Operating Profit or Operating Income + Non-Operating Net Income
EBITDA
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Like EBIT, EBITDA is a non-GAAP metric.
The focus is also on assessing a company’s profitability staying away from the financial aspects. This is the reason why EBITDA measures earnings before interest and taxes.
This is no surprise as both operating income and EBIT do the same. The three metrics don’t involve interest and taxes.
The big difference between EBITDA and the other two metrics — EBIT and EBITDA — is that EBITDA doesn’t consider non-cash items such as depreciation and amortization.
We can see this with EBITDA calculation starting with EBIT:
EBITDA = EBIT + Depreciation + Amortization
We can also write EBITDA calculation starting from operating income.
EBITDA = Operating income + Non-operating income + Depreciation + Amortization
Whether adding back non-cash items or not has generated heated discussions. Warren Buffet has been candid about his thoughts that businesses must consider depreciation and amortization as they are expenses to run their business. In his words, “does management think that the tooth fairy pays for capital expenditure?”
This discussion becomes more relevant in capital-intensive businesses where depreciation and amortization values are significant. Selecting the right metric(s) to use is critical to understand how a business and its supply chain are performing from the financial perspective.
Best Profitability Metric to Use
Which metric—operating income, EBIT, EBITDA—would you choose to show profitability from operations in your S&OP/ IBP, the area you highly impact with your work?
Let’s recap the calculations:
Operating Income or Operating Profit = Revenue – Cost of Goods Sold – Operating Expenses – Depreciation – Amortization
EBIT = Operating Profit or Operating Income + Non-Operating Net Income
EBITDA = EBIT + Depreciation + Amortization
The difference between EBIT and operating income is non-operating income. These are revenues and expenses that do not come from the core operations.
This implies that in many cases EBIT and operating income will be the same or similar.
The true question becomes whether EBITDA is a better option to show the business’ financial performance. This comes down to whether considering depreciation and amortization real business expenses.
Although they are non-cash items when recorded, it is a question of timing. For example, a growing business will require new machines and will replace others that are no longer working.
Without considering depreciation and amortization, companies with significant fixed assets will be overstating earnings. In the only context that EBITDA applies is for mature businesses with little or no capital.
Operating income or EBIT are better choices than EBITDA. If the focus is on operating profitability, operating income is best, as it does not include non-operating income.
