Cash flow check on accounting

Cash flow from operations or free cash flow?

Pardon the technical post and the prosaic title, but I hope it will explain why I rejected Smith & Nephew but retain Castings in the Thrifty 30. Smith & Nephew makes human parts (replacement knee joints for example) and Castings makes car parts, like steering knuckles.

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EBIT explained

A new series on frequently used terms starts

Where you’ll see EBIT

EBIT is used in Joel Greenblatt’s Magic Formula as the profit measure and numerator of the Return on Capital and Earnings Yield calculations. It’s part of the Return on Total Assets component of the Magic Formula inspired Nifty Thrifty screen developed for my Money Observer column of the same name.

EBIT Defined

Typically a company’s income statement, which explains how much profit a company retained over a period of time, is laid out as follows:

Revenue
- Cost of goods sold
Gross profit
- Operating expenses
Operating profit
+ Non operating income
- Interest payable
Profit before tax
- Tax payable
Profit after tax
- Dividend payable
Retained profit

At each stage, the amount of profit is reduced by costs grouped together into categories. To calculate gross profit, accountants take the company’s revenues for the period and deduct the direct costs of raw materials and stock sold. To calculate operating profit they deduct indirect costs like wages, for example, depreciation, and marketing.

After operating profit they add non-operating income, for example income from investments, and deduct debt interest to calculate profit before tax. Then they deduct tax to calculate profit after tax. The dividend is deducted from profit after tax, and the remainder, retained profit, is added to the balance sheet increasing (if it’s positive) the book value of the company.

EBIT stands for Earnings Before Interest and Tax. It’s the profit figure after operating costs but before interest and tax are deducted. Usually it‘s synonymous with operating profit, although technically EBIT includes non-operating income and, according to some definitions, exceptional items, for example income from the disposal of assets, subsidiaries say, or buildings. Where these are significant, the two measures will differ substantially.

EBIT = operating profit + non operating income

How I use EBIT

EBIT divided by Total Assets and expressed as a percentage gives ROTA, one of the fundamental profitability ratios, used in the Nifty Thrifty formula.

EBIT divided by Enterprise Value, the sum of a company’s market value and net debt, gives the Earnings Yield, the Nifty Thrifty’s measure of value.

I’ll explain these terms in future posts.

I only use EBIT in the computer generated Nifty Thrifty portfolio so I don’t calculate it for individual companies. If I did, I’d probably include investment income and exclude exceptional items since, by definition, exceptional items are unusual or one-off, they could make a company look more profitable or less profitable than it actually was.

Sharelockholmes, the database I use to generate the Nifty Thrifty recommendations calculates EBIT by taking Profit before tax and adding the interest back to it. This calculation includes both investment income and exceptional items.

Value-Investing.eu uses operating profit. This measure excludes both investment income and exceptional items.

In The Little Book that Still Beats the Market, Joel Greenblatt doesn’t explain the EBIT calculation in detail, although references to “actual operating earnings before interest expense and taxes” implies (to me) the Magic Formula uses the operating profit measure.

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Thanks to blippy, @brenmcl, @BryceElder, @mcturra200, @gpietersz, @SajKarsan and @V4Value, for helping me untangle EBIT, mostly in 140 characters!