Corporate Finance: Understanding Gross Income

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In corporate finance, gross income constitutes the operating result of a firm before taxes and other operating costs. It is also widely expressed with the acronym EBIT, which is derived from Earnings Before Interests and Taxes. EBIT indicates the income that the company is able to generate before the return on capital, including borrowed capital.

In the formulation of financial ratios it is used to obtain the ROI (Return on Investment, given by EBIT/Net Invested Capital), thus it represents the viability aspect in relation to the total capital invested in the business, regardless of its origin.

In practical applications and contrary to what the name suggests (that is, profit before interest and taxes), EBIT actually means “earnings before interest, taxes and extraordinary expenses.”

It does not include extraordinary (one time) costs and expenses like interest, other finance costs or income and taxes, because all these positions are not caused by the actual operational activity.

This is also entails tidying up of the gain or the taking out of certain positions: Revenue – raw materials – personnel expenses – else ref. expenses + else ref. income – depreciation on fixed assets + additions to fixed assets = EBIT.

Depreciation on fixed assets will be the adjustment for prior periods, extraordinary items or depreciation on, for example, special interests. Net income + taxes = EBT (Earnings Before Tax) + Interest on borrowings = EBIT.

It is often associated with net operating margin, but not conceptually identical with it: in addition to the components of operating income, including charges and revenues from ancillary operations (eg, managing assets for a manufacturing company), as well as financial gains from the so-called active financial management.

In companies that have no active ancillary financial aspects, EBIT coincides with the operating income. On the basis of EBIT, financial analysts and controllers are in a position to compare directly the operating profit of different fiscal years or quarters. Without varying tax rates, interest expenses or other distorted extraordinary factors.

Another application is the estimation of corporate value by using the multiplier method. The EBIT margin is the ratio of EBIT to sales: \ Mbox (EBIT margin in percent) = \ frac (\ rm (EBIT \ cdot 100)) (\ rm (Sales)). Similar to the return on sales, the EBIT margin indicates the viability of a company regardless of financial income, extraordinary items and taxes.

The EBIT margin is often used as a basis for profitability objectives, such as: achieving an EBIT margin of at least 9% within the next two fiscal years.
 

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