This is an accounting subject which has regularly bugged me, though I feel similar to I should know it. On the Income Statement the final line prior to Net Income is Earnings prior to seductiveness as well as taxes. What “interest” is this referring to? Most income statements only concede income taxation as well as afterwards we have net income.
WHAT IS THE “INTEREST” IN EBIT (EARNINGS BEFORE INTEREST AND TAXES)?
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The interest the company pays over its debt.
Interest has a special place here because it can be deducted from the taxes that have to be paid.
A company may dramatically and purposely reduce profits via the payment of interests. In this fashion the firm dramatically reduces the Tax expense. In addition, Bonds and loans interest tends to be lower than what investors require as return for their investment. EBIT may be a tool to see through a firms apparent low performance; in fact, because of this tax trick, the firm may be providing better return to current investors.
There is catch! It may be that the firm is highly leveraged (overburdened) with debt. Tax tricks will not help a firm whose operations don’t produce enough revenues and still have to pay a heafty fixed debt. Had the firm opted to sell stock, it would be on better financial grounds on rainy days.
By the way, this trick is not allowed to individuals (except for mortgage interest deduction). Personal interest is not eductible. I guess government does not want peopple crashing financially leveraging their expenses to reduce Uncle Sam’s bill. Besides, people get in debt anyway, no need to further incentivice it.
In summary:
1) Interest is permited to reduce income for tax purposes. .
2) Firms may issue bond (instead of stocks) because:
a) interest is cheper than paying dividends (and or increasing the value of stocks)
b) No new stock holders means more profits per shareholder.
c) Taxes will be less (there were more costs reported), just because instead of issuing stocks, the firm issued bond (or got a loan). While profits are “reduced” this way, value to current shareholders will be maximized (via better return on investor’s investment).
3. The catch: heavily leverage firms produce nice return on investors investment on good years. It can destry the firm on rainy days. Leverage firms may “pay” for this indirectly, via a lowered value of the firm.