Operating Income vs. EBITDA: What's the Difference? (2024)

EBITDA vs. Operating Income: An Overview

Two measures used for understanding a company's financial health are EBITDA (earnings before interest, taxes, depreciation, and amortization) and operating income. While both help gauge how well a company is doing when studying a balance sheet, they serve different purposes. In this article, you'll learn the differences between EBITDA and operating income, how they are calculated, and how each suits particular purposes.

EBITDA represents a company's core profitability by adding interest, tax, depreciation, and amortization expenses to net income. Meanwhile, operating income is a company's actual profits after subtracting its operational expenses or the costs of normal business operations.

EBITDA

The formulation of EBITDA is usually attributed to John Malone, the billionaire builder of a cable television empire. During the 1970s, he wanted a metric that could tell investors about the health of his company but not be clouded by figures related to his attempt to gain economies of scale during his company's expansion.

In the 1980s, EBITDA gained wide use in leveraged buyouts for its ability to assess whether potential acquisition targets could generate enough profits to cover the debt taken on during the buyout. Since a buyout would alter any firm's capital structure, tax obligations, depreciation, amortization, and noncash expenses, bracketing interest, taxes, and other such figures would clarify whether a company could manage additional debt.

However, not everyone agrees about the usefulness of EBITDA, which is not recognized under U.S. generally accepted accounting principles. The measure can obscure a debt burden that significantly hampers a company's profitability. In addition, EBITDA ignores capital investments, which can be burdensome, especially for fast-growing companies.

EBITDA is also susceptible to manipulation. Fraudulent accounting could boost revenue figures while removing interest, taxes, depreciation, and amortization from the financial picture, making almost any company appear robust.

How to Calculate EBITDA

Some companies report EBITDA in their financial results, while others note an adjusted EBITDA number that removes one-time items that may skew the data otherwise. If you're going to use EBITDA figures to analyze a company's profitability, it's important to know exactly how it's calculated and be aware of any adjustments.

You can calculate EBITDA with the following formula:

EBIDTA = Operating Income + Depreciation + Amortization

In this equation, operating income is the company's net earnings before deducting interest and taxes. You may also see this figure mentioned as earnings before interest and taxes or “EBIT.” The formula then adds depreciation, or the reduction in value of tangible assets, and amortization, which is the cost of intangible assets spread out over their useful life.

Operating Income

Operating income adds back some, but not all, of the figures excluded from EBITDA. It measures a company's profitability after accounting for operating expenses including wages, depreciation, and the cost of goods sold (COGS). However, it does not include the cost of taxes and one-off expenses that can skew the company's profit numbers. Investors value this figure because it gives them a sense of how well the company manages its costs.

A company with positive operating income is said to have an operating or recurring profit, if applicable. A company with an operating profit that increases year over year or quarter over quarter is more likely to continue making or increasing its profit.

How to Calculate Operating Income

There are several ways to calculate operating income. To determine operating income from the bottom up, where you start with the most basic or initial numbers and then add or subtract various elements to arrive at the final figure, you can use the following formula:

OperatingIncome = Gross Profit − Operating Expenses − Depreciation − Amortization.

You start with the company's gross or net profit after deducting COGS. Then, you subtract operating expenses, including the selling, general, and administrative costs of doing business. You then subtract depreciation and amortization to get the operating income.

Alternatively, you can determine operating income from the top down. If you know a company's net income—which is used to calculate earnings per share and often reported on the last line of the income statement—you can determine the operating income by adding back the expenses that were deducted in the net income calculation:

OperatingIncome = Net Income + Interest Expenses + Tax Expenses

EBITDA vs. Operating Income Example

The difference between EBITDA and operating income is best understood by studying a real income statement, such as this one from JC Penney CompanyInc.(JCP), released May 10,2018:

• Operating income was $3 million (highlighted in blue).
• Depreciation was $141 million, but the $3 million in operating incomeincludes subtracting the $141 million in depreciation and amortization (highlighted in red). As a result, depreciationand amortization areadded back into operating incomeduring the EBITDA calculation.
• EBITDA was $144millionfor the period, or $141 million + $3 million.
• Interest expenses and taxes are not included in operating income but are counted in net income.

JC Penney's EBITDAof $144 million differed drastically from its operating income of $3 million for the same period. When comparing EBITDA and operating expenses, one metric is not necessarily better. They indicate the company's profit differently—by stripping out or adding back some costs.

EBITDA vs. Operating Income: Key Differences

Operating income includes the company's overhead and operating expenses, depreciation, and amortization. However, operating income does not include interest on debt and tax expenses.

To calculate EBITDA, noncash items like depreciation, taxes, and capital structure arestripped from the equation.

While EBITDA helps the investor see past possiblemanagement manipulation by removingdebt financing, operating incomecan help analyze the production efficiency of a firm's core operations.

EBITDA vs. Operating Income: When to Use Each Figure

EBITDA and operating income offer different views of a company's viability. The choice of either depends on the specific company you're looking at and what information you're looking to find. EBITDA is valuable for evaluating certain companies, given its focus on earnings potential rather than actual operational profits. This characteristic has led some critics to argue that EBITDA can overstate a company's profitability.

Its advocates say EBITDA is particularly useful for companies investing in expensive equipment or other large assets that depreciate over time. They note that since depreciation expenses do not correspond to real cash outflows, excluding them offers a more accurate representation of a company's health. In addition, since there are several ways to calculate depreciation, leaving this figure out eliminates potential inconsistencies, making it easier to compare companies. The exclusion of taxes and interest expenses also makes EBITDA helpful for analyzing firms with very different tax and debt profiles,

By contrast, operating income does not account for earnings potential but reflects the profits generated from a company's core operations. It provides a view of a company's ability to generate revenue after accounting for operating expenses.

Investors rely on operating income to gauge the effectiveness of company management and a firm's underlying financial health. Operating income can also give you a company's operating profit margin, representing the percentage of total revenue remaining as operating profit after subtracting expenses.

The Bottom Line

EBITDA and operating income are two ways to measure a company's profitability. Operating income focuses on the profits generated by core business activities, while EBITDA adds back depreciation and amortization expenses. As such, operating income reveals the real profits emerging from a company's operations, while EBITDA shows a company's broader capacity to generate profits, accounting for its assets and capital structure.