What Is EBIT-EPS Analysis and How to Calculate it?

EBIT-EPS analysis is a financial tool offering a data-driven financial decision-making approach. It helps companies achieve optimal capital allocation and maximise shareholder value. The article will explore the process of EBIT-EPS analysis in detail, along with a real-life example.

 

What is EBIT-EPS Analysis?

EBIT-EPS (earnings before interest and taxes - earnings per share) analysis is a valuable tool for understanding how different financing decisions can affect a company's profitability for shareholders. It is used in financial planning to evaluate different financing options and their impact on a company's earnings per share (EPS).

It helps answer questions like:

• How will using more debt impact earnings per share under different scenarios?
• Is it better to issue new equity or take on debt for a specific project?
• What is the break-even point where EPS stays the same under different financing plans?

By understanding the relationship between EBIT, leverage, and taxes, businesses can make informed decisions about their capital structure and maximise shareholder value.

How to Calculate EBIT-EPS?

EBIT-EPS calculation for debt financing involves five actionable steps. Let us take a look into these steps - 

Step 1: Determine Capital Requirement

Start by identifying the precise capital injection your company needs. Underestimate, and you face operational bottlenecks later. Overestimate, and you saddle yourself with excess debt and unnecessary interest expenses. Evaluate alternative financing options like equity issuance, but choose the method that aligns with your projected cash flow and growth plans.

Step 2: Identify Your Starting Point - EBIT

EBIT, or net operating income, is the foundation for debt financing calculations. It's calculated as Gross Operating Income (total sales) minus Operating Expenses (business costs). EBIT represents your underlying profit potential, untainted by any financial leverage.

Step 3: Factor in Debt Costs

Let's factor in the cost of your debt. Multiply the loan amount by the annual interest rate to determine the annual interest expense. This is the "price tag" for employing borrowed funds. Subtract this expense from your EBIT to reach EBT (Earnings Before Taxes). EBT signifies your profit after servicing the debt burden.

Step 4: Calculate After-Tax Earnings

The taxman looms large – estimate your projected tax liability based on applicable tax rates. Subtract this "tax bite" from your EBT to arrive at EAT (Earnings After Taxes). EAT represents your net income, reflecting the combined impact of debt costs and taxes on your bottom line.

Step 5: Calculate EPS with Outstanding Shares

Finally, let's see how much of this remaining profit flows to each shareholder. Since debt financing doesn't involve issuing new shares, divide your EAT by the number of outstanding shares in your company. This magical metric, EPS (Earnings Per Share), tells you how much profit each share translates to after considering debt and taxes.

Pro Tip: This calculation is dynamic. Fluctuations in interest rates, taxes, or your business performance can impact your EBIT-EPS. Regularly recalculate and adapt your financial decisions to maintain optimal financial health.

EBIT-EPS Calculation - Real-Life Example 

Scenario: OrionTech Electronics is considering two financing options for its expansion:

Option 1: Secure a ₹50 crore loan at a 7% interest rate.

Option 2: Issue new equity shares, raising ₹50 crore in capital.

Current Financials

Revenue	₹120 crore
Cost of Goods Sold	₹80 crore
Operating Expenses	₹20 crore
EBIT	₹20 crore
Net Income	₹14 crore
Shares Outstanding	5 million
EPS	₹2.80

Analysis

Option 1: Taking a loan

• Interest Expense: ₹3.5 crore (₹50 crore loan x 7% interest rate)
• Shares remain the same.
• Assume EBIT remains unchanged.

EPS = (₹20 crore EBIT - ₹3.5 crore interest) x (1 - 30% tax rate) / 5 million shares = ₹3.15.

Option 2: Issuing new shares

• No interest expense.
• Increased shares outstanding to 7 million (5 million + 2 million new shares).
• Assume EBIT remains unchanged for simplicity.

EPS = (₹20 crore EBIT - ₹0 interest) x (1 - 30% tax rate) / 7 million shares = ₹2.43.

Results:

Option 1: ₹3.15 EPS

Option 2: ₹2.43 EPS

Conclusion

• In this case, Option 1 (taking a loan) with an EPS of ₹3.15 is the better choice for OrionTech Electronics.
• Despite the interest expense, it results in a higher EPS compared to Option 2.
• The company can leverage the loan to achieve a more efficient financial outcome.

Consideration for OrionTech Electronics:

• Ensure that the company can manage the loan payments effectively and that the expected return on investment from the expansion justifies the interest expense.
• Weigh the benefits of immediate EPS growth against the financial burden of servicing the loan.

Advantages of EBIT-EPS Analysis

EBIT-EPS analysis serves as a strategic roadmap to financial growth and offers several potential benefits for businesses and investors, including -

• It allows you to identify and mitigate potential financial landmines associated with various funding strategies.
• You can strike the ideal balance between debt and equity to maximise EPS.
• It allows businesses to foster trust and transparency by clearly communicating the financial implications of funding decisions.
• Businesses can compare the financial landscapes of different funding options to select the most advantageous route.
• EBIT-EPS analysis aids in predicting the long-term impact of financial choices on profitability and growth.

Limitations of EBIT-EPS Analysis

• EBIT-EPS analysis primarily emphasises maximising EPS, potentially overlooking other critical financial factors like stability, liquidity, and risk management.
• It doesn't account for the increased risk associated with higher debt levels, which can be problematic during economic downturns.
• EBIT-EPS analysis does not consider external economic factors like interest rates and economic cycles.
• It doesn't address the risk of overcapitalisation, which means that adding more debt or equity may not generate enough profits to justify their expenses. 

Key Takeaways

• EBIT-EPS analysis quantifies the impact of financial decisions on per-share profitability (EPS), driving shareholder value.
• The process involves identifying capital needs, starting with EBIT, factoring in debt costs, calculating after-tax earnings, and determining EPS with outstanding shares.
• EBIT-EPS analysis aids in risk mitigation, optimising capital structure, fostering transparency, comparing financing options, and making long-term predictions.
• It focuses primarily on EPS, ignores risk associated with debt, excludes external economic factors, and doesn't address overcapitalisation risks.