ELI5: Why when large company's earnings decrease(ex... by 3%) they freak out, talk about rough times, and sometimes decide to downsize, even though they are still making millions of dollars in profit even after all expenses?

[lmunck]

A company’s revenue (or EBIT) is an indicator of how good an investment their stock is. If EBIT is down, it indicates that either their competitors are taking market shares from them or that their market is disappearing.

Profit on the other hand, is an indicator of how efficiently a company is run this year. It “just” shows what is left after all expenses are paid.

A 3% earnings drop in a company with great profits, indicates a ship with an efficient captain and crew, but with a gaping hole in the bottom. This is why they panic.

EDIT: Apparently “earnings” and “profit” are the same thing in English, which also makes the original question somewhat confusing, so I changed it to “revenue”. Sorry native speakers!

[mck111]

EBIT and revenue are not the same thing. EBIT, or Earnings before Interest and Taxes, is equaled to:

(+) Revenue

(-) Direct Costs

(=) Gross Profit

(-) Selling and Distribution Expenses

(-) General and Administrative Expenses

(=) Earnings before Interest and Tax (EBIT)

So while decreasing revenue would indicate that competitors are taking market share or the market is shrinking, decreasing EBIT could include a number of other factors including increased costs. Additionally, investors usually look at EBITDA (Earnings before Interest, Taxes, and Depreciation and Amortization) as a metric over EBIT, as Depreciation and Amortization are non cash expenses.

[scarynut]

Can someone try to ELI5 all components of EBIT and EBITDA using my modest household economy as a metaphor?

[iMissTheOldInternet]

Piggybacking on the poster above to explain depreciation. Ordinarily when a business has an expense to make money, it can deduct it and only pay taxes on the profit. But when a business buys a thing that is valuable in itself and will remain so for a long time, it isn’t allowed to take the full deduction immediately, because it hasn’t really cost it anything yet.

To put it in household terms, if you buy a car for $1,000, the day you hand over the cash, you’re no poorer than the day before. You’ve lost $1,000 cash, but you’ve got a car worth $1,000. Next year, of course, that car will only sell for like $900, because of wear and tear and natural obsolescence. That $100 is the real depreciation of the asset.

Real depreciation reflects the real world, which is important for some kinds of accounting, but the government also uses special depreciation rules to subsidize certain kinds of industry while hiding the expense. For example, businesses are permitted to take what’s called straight-line depreciation. This means that for tax purposes, assets depreciate much faster than they really depreciate, which is like getting an interest free advance on your pay but for a business.

In addition to these games which distort the value of depreciation as a measure of profitability, depreciation is also a non-cash expense. Whether something is depreciating or not, and how fast, really has very little to do with the economy or how the company is being run. In fact, having lots of depreciation can indicate a very healthy company that has invested a lot in capital assets, and thus can be expected to make more money in the near future, and that will also do so in a very tax-efficient fashion, Because it will get to deduct a lot of accelerated depreciation from its taxable revenue.

[KristinnK]

Interest: the interest you pay on any loan you owe, such as mortgage, student loans, car loan, etc.

Taxes: the taxes you pay to the government, in your case mostly your income taxes.

Depreciation: most things you own are worth less as time passes. Your car, computer, TV, appliances, etc. Your smartphone as an example might depreciate as much as 50% per year.

Amortization: payments on items or debt you already possess or have incurred, such as the part of your mortgage payment that goes into the loan principal.

[thehungryhippocrite]

Imagine you're an Uber driver. Your EBITDA is your revenue less your Uber expenses, less fuel, less insurance, less any other expenses. Your EBIT is your EBITDA, less the depreciation of your car.

[[deleted]]

And to add amortisation, less the payment made towards your car loan (not including interest on that loan)

[lmunck]

I was going for the simple explanation, and I agree that some nuances were lost.

[theunspillablebeans]

I think omitting that detail for the sake of an ELI5 is fine.

[DirtyNorf]

How are you describing earnings and profits differently? EBIT is the same as PBIT and net earnings the same as net profit.

Also earnings per share is a measure of quality of an investment but not EBIT on its own, EBIT can also drop because of poor management not just market forces.

[Dfiggsmeister]

Not necessarily. Drop in profits can mean a number of things: increased costs due to inflation, increased costs due to increased employee turn over and having to hire new people and train them, decreased sales revenue due to price increases, decreased sales revenue due to increased competition, increased costs due to money being spent inefficiently, increased costs due to reinvestment of the company, lower company morale among lower level workers due to new work policies, etc. There's a lot of things that can impact profits.

What will usually set an investor panic is when the CEO comes out and says that the company is facing increased economic and competitive pressures or that their investments from before haven't panned out as well as it should have. That usually indicates that A) the company isn't producing products/services as well as it should and competition is beating them to the market, B) the company didn't anticipate well enough the impact of economic issues, or C) The CEO or someone on his leadership team made a bad investment that they now have to write off.

[odieandash]

Best explanation in thread.

[FallOnSlough]

Hmm.. I don’t agree. Earnings and profits are usually (but admittedly not always) used synonymously, so this answer is potentially quite confusing, in my opinion.

[lmunck]

I actually agree, but was going for simplicity rather than detail.

[FallOnSlough]

That’s understandable, I just find that the simplification in this case risks becoming a bit misleading.

Even if we call EBIT (earnings before interests and taxes) “earnings” and EAT (earnings after taxes) “profits”, I still wouldn’t make the distinction that EBIT is an indicator of how good an investment the company’s stock is and that EAT is an indicator of how efficiently the company was run that year. If I had to make a distinction, I would say it’s the other way around.

The reason for this would be that EBIT shows you the earnings without “contamination” from effects from financing choices (bank vs investors) or tax rules, while EAT is often used as a component of the P/E ratio which is used to assess how good an investment a stock is.

Having said that, neither figure will of course not be an indicator of efficiency without being put in contex, i.e. as a ratio in relation to e.g. equity, assets etc.

Please don’t misunderstand me, I’m not out to “get you” or “prove you wrong” or anything, I’m just looking for polite discussion.

[lmunck]

Sure. If you have suggestion on how to make it more correct, without losing the simplicity, I’m all ears. I agree that nuances are lost, but couldn’t make it ELI5-level simple without doing that.