EBIT-EPS ANALYSIS

Earnings Before Interest and Taxes (EBIT)

EBIT or the operating income is the profitability measurement
which determines the company’s operating profit.

1. It shows the amount of profit that the company generates

from its operating activities only.

2. Here the expenses pertaining to the interest and taxes are

not considered for calculating the EBIT as they do not arise
due to the operating activities and that’s why it means
operating profit or operating earnings.

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 METHODS
It can be calculated by using the direct and indirect method.

#1 – Direct Method #2 – Indirect Method

EBIT = Revenue – COGS – EBIT = Net income +
Operating Expenses Interest expenses + Tax
• Revenue expense
• Cost of Goods Sold
(COGS)
COGS = Opening inventory
+ purchases of raw
material + direct labor +
overheads – closing
inventory
• Operating Expenses

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Example
The income statement of Harry Corporation reported the following activities.
• Sales Revenue from operations: ` 25,00,000
•COGS: `14,00,000
•Operating Expenses: `4,00,000
•Interest Expense: ` 2,00,000
•Income Tax : ` 30,000
Calculate EBIT

Solution:
Now from the figures we can calculate gross profit (Revenue – COGS)
GP = ` 25,00,000 – `14,00,000
Gross Profit = ` 11,00,000
And Net Income = Gross profit – Operating Expense – Interest expense – tax expense
= `(11,00,000 – 4,00,000 – 2,00,000 – 30,000)
Net Income = ` 4,70,000
Now we need to calculate EBIT from the two methods:
•Sales Revenue from operations: ` 25,00,000
By Direct Method
EBIT = `(25,00,000 – 14,00,000- 4,00,000) = ` 7,00,000
By Indirect Method
EBIT = `(4,70,000 + 2,00,000 + 30,000) = ` 7,00,000

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 Particulars `
Sales Revenue 25,00,000
Less: COGS 14,00,000
Gross Profit 11,00,000
Less: Operating Expenses 4,00,000
Earnings Before Interest and Taxes(EBIT) 7,00,000
Less: Interest Expenses 2,00,000
Earnings Before Taxes(EBT) 5,00,000
Less: Income Tax 30,000
Net Income 4,70,000

In this example, EBIT is `7,00,000 while net income is ` 4,70,000.

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 Why Does Earnings Before Interest and
Taxes (EBIT) Matter?
EBIT provides investment analysts with useful
information for evaluating a company’s operating
performance without regard to interest expenses
or tax rates.
EBIT helps minimize these two variables that may
be unique from company to company, and enables
one to analyze operating profitability as a singular
measure of performance.

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 EARNINGS PER SHARE
The term earnings per share (EPS) represents the
portion of a company's earnings, net of taxes and
preference dividends, that is allocated to each
share of common stock.
The figure can be calculated simply by dividing net
income earned in a given reporting period (usually
quarterly or annually) by the total number of shares
outstanding during the same term.

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 How Does Earnings Per Share (EPS) Work?
Let's assume that during the fourth quarter,
Company XYZ reported net income of `4,00,000.
During the same time frame, the company had a
total of 10,000 shares outstanding. In this particular
case, the company's quarterly earnings per share
(or EPS) would be `40, calculated as follows:

EPS = `4,00,000 / 10,000 shares = `40

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Why Does Earnings Per Share (EPS) Matter?

EPS is the portion of a company’s profit

that is allocated to every individual share
of the stock. It is a term that is of much
importance to investors and people who
trade in the stock market. The higher the
earnings per share of a company, the
better is its profitability.

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A Ltd., has an EBIT of Rs 3, 20,000. Its capital structure is given as under:

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 EBIT-EPS Analysis
a) A scientific basis for comparison among various financial plans and
shows ways to maximize EPS.
b) A tool of financial planning that evaluates various alternatives of
financing a project under varying levels of EBIT and
c) suggests the best alternative having highest EPS and determines the
most profitable level of EBIT’.
A firm has various options regarding the combinations of various sources to
finance its investment activities.
The firms may opt to be an
i) all-equity firm (and having no borrowed funds) or
ii) equity-preference firm (having no borrowed funds) or
iii) any of the numerous possibility of combinations of equity, preference
shares and borrowed funds.
Given a level of EBIT, a particular combination of different sources of
finance will result in a particular EPS and therefore, for different financing
patterns, there would be different levels of EPS.

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 Constant EBIT and Changes in the Financing Patterns

Suppose, ABC Ltd. which is expecting the EBIT of Rs.1,50,000 per

annum on an investment Rs.5,00,000, is considering the
finalization of the capital structure or the financial plan. The
company has access to raise funds of varying amounts by issuing
equity share capital, 12% preference share and 10% debenture or
any combination thereof. Suppose, it analyzes the following four
options to raise the required funds of Rs.5,00,000.
1. By issuing equity share capital at par.
2. 50% funds by equity share capital and 50% funds by
preference shares.
3. 5% funds by equity share capital, 25% by preference shares
and 25% by issue of 10% debentures.
4. 25% funds by equity share capital, 25% as preference share
and 50% by the issue of 10% debentures.
Assuming that ABC Ltd. belongs to 50% tax bracket, the EPS under
the above four options can be calculated as follows:
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 Option 1 Option 2 Option 3 Option 4
Equity share capital Rs.5,00,0000 Rs.2,50,000 Rs.2,50,000 Rs.1,25,000

Preference share capital --- 2,50,000 1,25,000 1,25,000

10% Debentures --- --- 1,25,000 2,50,000
Total Funds 5,00,000 5,00,000 5,00,000 5,00,000
EBIT 1,50,000 1,50,000 1,50,000 1,50,000
- Interest --- --- 12,500 25,000
Profit before Tax 1,50,000 1,50,000 1,37,500 1,25,000
- Tax @ 50% 75,000 75,000 68,750 62,500
Profit after Tax 75,000 75,000 68,750 62,500
- Preference Dividend --- 30,000 15,000 15,000
Profit for Equity shares 75,000 45,000 53,750 47,500
No. of Equity shares (of 5000 2500 2500 1250
Rs.100 each)
EPS (Rs.) 15 18 21.5 38 12
 In this case, the financial plan under option 4 seems to be the best as it is giving the highest
EPS of Rs.38. The firm is expecting to earn 30% return. After-tax, this return comes to 15% i.e.,
30% x (1-.5).
However, the after tax cost of 10% debentures is 5% [10% (1- .5)] i.e. the co. saved 10% on
`250000 i.e. ` 25000.
the after tax cost of preference shares is 12% only. The co. saved 3% on ` 125000 i.e. ` 3750.
In the option 4, the firm has employed 50% debt, 25% preference shares and 25% equity
share capital, and the benefits of employing 50% debt (which has after tax cost of 5% only) and
25% preference shares (having cost of 12% only) are extended to the equity shareholders. Total
savings ` (25000+ 3750) = ` 28750, which will be shared by the existing shareholders. So per share
increase will be ` 28750/1250= ` 23. Therefore the firm is expecting an EPS of ` 15+23= ` 38.
However, in option 2, where 50% funds are obtained by the issue of 12% preference shares,
the 3% extra is available to the equity shareholders resulting in increase in of EPS from ` 15 to `
18.
In plan 3, where 10% debt is also introduced, the extra benefit accruing to the equity
shareholders increases further (from preference shares as well a from debt) and the EPS further
increases to Rs.21.50. The company is expecting this increase in EPS when more and more
preference share and debt financing is availed because the after tax cost of preference shares and
debentures are less than the after tax return on total investment.
Hence, the financial leverage has a favourable impact on the EPS-only if the ROI is more than
the cost of debt. It will rather have an unfavourable effect if the ROI is less than the cost of debt.

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 Varying EBIT with Different Patterns
Suppose, there are three firm X&Co., Y&Co. and Z&
Co. These firms are alike in all respect except the
leverage. The financial position of the three firms is
presented as follows:
Capital Structure X & Co. Y & Co. Z & Co.
Share Capital (of Rs.100 each) Rs.2,00,000 Rs.1,00,000 Rs.50,000
6% Debenture --- 1,00,000 1,50,000
Total 2,00,000 2,00,000 2,00,000
These firms are expected to earn a ROI at different levels
depending upon the economic conditions. In normal conditions,
the ROI is expected to be 8% which may fluctuate by 3% on
either side on the occurrence of bad economic conditions or good
economic conditions. How is return available to the shareholders
of the three firms is going to be affected by the variations in the
level of EBIT due to differing economic conditions?

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The relevant presentations have been shown as follows:
Poor Eco. Cond. Normal Eco. cond. Good Eco. Cond.
Total Assets Rs.2,00,000 Rs.2,00,000 Rs.2,00,000
ROI 5% 8% 11%
EBIT Rs.10,000 Rs.16,000 Rs.22,000
X & Co. (No Financial Leverage) (Figures in Rs.)
EBIT 10,000 16,000 22,000
- Interest --- --- ---
Profit before Tax 10,000 16,000 22,000
- Tax @ 50% 5,000 8,000 11,000
Profit After Tax 5,000 8,000 11,000
Number of Shares 2,000 2,000 2,000
EPS (Rs.) 2.5 4 5.5
Y & Co. (50% Leverage) (Figures in Rs.)
EBIT 10,000 16,000 22,000
- Interest 6,000 6,000 6,000
Profit before Tax 4,000 10,000 16,000
- Tax @ 50% 2,000 5,000 8,000
Profit After Tax 2,000 5,000 8,000
Number of Shares 1,000 1,000 1,000
EPS (Rs.) 2 5 8
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 Z & Co. (75% Leverage) (Figures in Rs.)
EBIT 10,000 16,000 22,000
- Interest 9,000 9,000 9,000
Profit before Tax 1,000 7,000 13,000
- Tax @ 50% 500 3,500 6,500
Profit After Tax 500 3,500 6,500
Number of Shares 500 500 500
EPS (Rs.) 1 7 13
On the basis of the figures given above, it may be analyzed as to how the EPS affects
the returns available to the shareholders under varying EBIT level. For this purpose, the
normal rate of return i.e. 8% and EPS of different firms in normal economic conditions, both
may be taken at 100 and position of other figures of EBIT and EPS may be shown on
relative basis as follows:
Poor Eco. Cond. Normal Eco. cond. Good Eco. cond.
EBIT 62.5 100 137.5
X & Co.
EPS 62.5 100 137.5
% change from normal - 37.5% ---- + 37.5%
Y & Co.
EPS 40 100 160
% change from normal -60% ----- +60%
Z & Co.
EPS 14.3 100 185.7
% change from normal - 85.7% ----- +85.7%

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 Advantages of EBIT-EPS Analysis
• Financial Planning
• Comparative Analysis
• Performance Evaluation
• Determining Optimum Mix
Limitations of EBIT-EPS Analysis:
1. No Consideration for Risk
2. Contradictory Results:
3. Over-capitalization:

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 Financial Breakeven Point
Financial breakeven point is the level of EBIT at
which after paying interest, tax and preference
dividend, nothing remains for the equity
shareholders.
In other words, financial breakeven point refers to
that level of EBIT at which the firm can satisfy all
fixed financial charges. EBIT less than this level will
result in negative EPS. Therefore EPS is zero at this
level of EBIT. Thus financial breakeven point refers
to the level of EBIT at which financial profit is nil.
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Financial Break Even Point (FBEP) is expressed as ratio with the following equation:

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Example :
A company has formulated the following financing plans to finance Rs 15, 00,000 which is required for
financing a new project.

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 Indifference Level / Points
The indifference level of EBIT is one at which the
EPS remains same irrespective of the debt equity
mix.
Out of several available financial plans, the firm
may have two or more financial plans which result
in the same level of EPS for a given EBIT.
Such a level of EBIT at which the firm has two or
more financial plans resulting in same level of EPS,
is known as indifference level of EBIT.

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 Computation
There are two approaches to calculate indifference point:
Mathematical approach and Graphical approach.
Example : Debarathi Co. Ltd., is planning an expansion
programme. It requires Rs 20 lakhs of external financing for
which it is considering two alternatives. The first alternative
calls for issuing 15,000 equity shares of Rs 100 each and
5,000 10% Preference Shares of Rs 100 each; the second
alternative requires 10,000 equity shares of Rs 100 each,
2,000 10% Preference Shares of Rs 100 each and Rs 8,00,000
Debentures carrying 9% interest. The company is in the tax
bracket of 50%. You are required to calculate the indifference
point for the plans and verify your answer by calculating the
EPS.

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Graphical Approach

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