Hello, I have heard different stories on how to calculate operating profit for coverage of interest exp. I initially caluated EBIT from top down: Sales - COGS - SGA and making sure int xp was excluded. But, I have seen others calculate EBIT as Profit before taxes + interest xp. How would one calculate operating profit here for coverage of int xp: Sales 10.0 COSTS & EXPENSES: --------------------------- COGS 4.0 Marketing and selling XP 0.8 Admin XP 0.3 Research and devel 0.6 interest xp 0.2 Interest income -0.1 Foreign xc losses 0.1 Other xp 0.1 -------------------------------------------------------- Total Costs and XP 6.0 Earn. before eq. in earn of affil & min int 4.0 Equity in earning of affil 2.0 Minority int -1.0 ---------------------------------------------------------- Earnings before taxes 5.0 Option 1: ----------- I thought that operating profit (EBIT) would be top down: Sales - COGS - Market XP - Admin XP - R&D = 10-4-.9-.3-.6 = 4.2 EBIT basically all exp summed up to but not including the interest xp. Option 2 ----------- But after reading in one of the books now I think EBIT is calculated as bottom up: EBT + int xp = 5+.2 = 5.2 EBIT. However, this means that both minority int & equity in earnings of affil. are operating xp’s and I dont think they are. How do other analysts calculate EBIT for covereage of int xp?
I’ve always used what you are referring to as “top down” since I’m trying to get to operating income. However, I have on occasion included earnings from affiliates if I know that the affiliates are in the same line of business, as you’d often see in pharma jv’s and natural resources. Yes, I know that the earnings in affiliates are net of tax and interest but it’s really more of a qualitative call. I’ll also add back the revenue from affiliates when thinking about operating profit margins if I have the data. I don’t include transaction Fx from the P&L, however, in my experience most Fx exposure is translation rather than transaction, so it’s already baked into the numbers. I don’t include interest income because it’s non-operating, presumably from excess cash and securities that I’m going to separately add to EV. I don’t include minority interest because the number just representing the portion of some sub’s earnings which aren’t wholly owned by the parent company. If there is any debt/interest expense from these subs, it’d already be reflected 100% in interest expense so it doesn’t make sense to me to include minority interest in EBIT.
SOMA80, thanks for the reply. The book I am using gives option 2 as the correct way to calculate operating profit for coverage of interest exp. I think you are saying that Option 1 might be better. Minority int, equity in earnings of affil. foreign xc and other xp should not be available to cover interest charges but the book says they are operating.
Either way is correct. Top-Down and Bottom-Up are both used in industry. I can tell you that my firm uses Top-Down because it is more conservative and we aire on the side of caution when managing our portfolio.
I think if you’re looking for the definition of EBIT that most accurately reflects “operating profit” you would want to use the “top down” approach so as to exclude other non-operating items such as fx and investment income. On the actual CFA exams there is little ambiguity in regards to what you should be calculating. FYI - Additionally some analysts prefer to use EBITDA/Int as the times interest earned (interest coverage) as it more accurately proxies the cash flows available to service the interest payments.
>FYI - Additionally some analysts prefer to use EBITDA/Int as the times interest earned (interest coverage) as it more accurately proxies the cash flows available to service the interest payments. Do you mean (ebitda-capex)/Int ?
Darien,