EBITDA Income Statement: What Financial Metrics Investors Should Look For in Chinese Statements ( Part 2)
In the previous article, we shared the concept and role of EBIT and EBITDA, two crucial financial data. Content can be reviewed on our webiste: www.serviceonnewgrounds.com. In this article, we will further explain the various components of EBIT and EBITDA so that investors can clearly understand why they should obtain them and what they mean.
- Analysis of the components
- Net profit
Net profit is the amount of the company’s total profit for the period minus income tax, i.e., the company’s profit after tax. Net Profit is the final result of a company’s operations and is usually presented at the bottom of the P&L Statement after EBIT, indicating the effectiveness of the company’s operations during a given accounting period.
Interest is generally defined as interest expense incurred based on financing, other borrowing, discounting, etc., with special attention being paid to the fact that the interest does not include the interest income. There is a difference between this and the Financial Expenses in the P&L Statement. Financial Expenses in the P&L Statement include:
- interest income and expenses (interest expense minus (-) interest income);
- exchange profit or loss (exchange losses minus (-) exchange profits);
- bank charges;
- cash discounts, etc.
When we calculate the EBIT & EBITDA metrics, only the interest expense component is extracted. The deduction of interest expense is calculated because the same industry generates different interest rates due to different financing costs in different regions.
For example, some prefecture-level cities will sign betting agreements with large companies to provide large interest-free loans to companies as start-up capital, and the correspondingly, company needs to fulfill the tax target in the future years, which can be seen in the company’s financing costs are low, and the interest expense is almost zero. In some areas where financing is difficult, the interest rate is relatively high, and the interest expense is also high. These fluctuating factors, which affect the net profit of the companies, are not affected in the EBIT & EBITDA indicator.
- Income tax
Income tax, generally referred to as Corporate Income Tax (CIT), is an income tax levied on the production & operations income and other income of 1) companies and 2) other organizations that derive incomes.
CIT is levied in all countries and regions, but the time, method, and rate of levy vary. For example,
- in China, quarterly prepayment of CIT is required, and the CIT rate is 25%. Certainly, if the company is recognized as a small micro-company, and the annual profit is less than CNY 3 million, it can enjoy a preferential tax rate of 5% (in accordance with the latest policy in 2023).
- in the United States, state tax laws vary, but usually, income tax returns must be completed by April 15 each year (U.S. time), and the basic income tax rate is 21%, but of course, there are appropriate relief measures.
The factor of income tax, which varies from country to country in terms of when it is levied and at what rate, affects the net profit of a company but is not affected by the EBIT & EBITDA metrics.
Depreciation is the systematic apportionment of accrued depreciation over the useful life of a fixed asset in accordance with a defined method.
Different types of fixed assets are subject to different statutory minimum depreciation periods, and the method of depreciation allocation and the recognition of residual value varies according to the business needs of the company.
Fixed assets are generally large in subject matter and have long useful lives. They are usually acquired initially or in the short term, resulting in an instantaneous net cash drain to the company. For example, for aircraft engines, usually purchased at a cost of 12 million U.S. dollars (equivalent to 86.4 million yuan), the depreciation period of fixed assets can be up to 20 years, and the annual depreciation of fixed assets of the company will affect the net profit, but in up to 20 years, only the previous period (or a shorter period of time) when the payment is made, it will affect the company’s net cash flow.
Investors are most interested in the net cash flow of the tranche rather than the cost of fixed assets paid in past years, however, the depreciation itself is an indirect measure of past capital expenditures. Therefore, in the EBITDA metric, the company’s true net cash flow for the current period can be presented, and investors can more easily focus on the estimation of future capital expenditures rather than the sunk costs of the past.
Amortization generally refers to long-term amortized expenses: economic management activities that amortize expenses that have been incurred by the company but have an amortization period of more than one year (excluding one year).
Long-term amortized expenses mainly include:
- fixed asset repair expenditure,
- expenditures for leasehold improvements of fixed assets, and
- other amortized expenses with an amortization period of more than 1 year.
This element, as described in point 4), due to the large initial cost of acquiring long-term amortizes, a short period of time results in a net loss of cash and amortization of long-term amortization expense in subsequent years.
Amortization itself is an indirect measure of past capital expenditures. However, in the EBITDA metric, the company’s true net cash flow for the current period can be presented, and investors can more easily focus on the estimation of future capital expenditures rather than the sunk costs of the past.
Some investors would believe that annual net profit is also an important indicator of how well a company is operating. This is something that we will explain further in our next article, about some of the differences between Net Profit and EBIT & EBITDA indices, and introduce case studies to further analyze.
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