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What is EBIT-EPS Analysis?
The EBIT-EPS analysis gives the best ratio of debttoequity which the businesses can use to find an optimum balance in their debt and equity financing. The analysis shows the effect of the balance sheet’s structure on the company’s earnings.
Basics of EBIT-EPS Approach
It is important to understand what EBIT and EPS mean to understand what the analysis is meant to be.
EBIT refers to earnings before interest and tax. The metric makes interest and taxes irrelevant. Therefore, an investor can understand how the company is performing out of the balance sheet’s composition which essentially makes interest and taxes the focal point of consideration. In terms of EBIT, there is no difference if a company has huge debt or no debt at all. The repercussions will be the same.
EPS or earnings per share is the metric that shows a company’s earnings including interests and taxes. It is an important metric because it shows the earnings on a per-share basis which helps the investors understand how a company performs on an overall basis. If a company’s overall profit soars high but the payment to investors is low, it is a bad gesture for investors owning a fixed number of shares. EPS shows this dynamic rule simply and in a clear manner.
The ratio between these two metrics can show how the bottomline results, the company’s EPS, are related to its performance irrespective of its capital structure, the EBIT.
Limitations of EBIT-EPS Analysis
Although EBIT-EPS analysis is a good way to check the earning sensitivity of a company, it has certain limitations too.
No Consideration of Risk
The EBIT-EPS analysis does not consider the risk associated with a business project. It simply shows whether the earnings are enough for a corporation. It is not needed in case of a profit larger than returns, but it can be hurting if the opposite situation is there. When the profits are low, but the interest is high, then businesses may be in turmoil.
When new equity shares are not considered in a different alternative financial plan, the results arising out of this can get erroneous. The comparison of plans also becomes difficult when the number of alternatives increases.
Over-capitalization of Funds
This analysis ignores the over-capitalization of the funds. Beyond a certain point, additional capital should not be employed to generate a return in excess of the payments that should be made for its use. The analysis does not address such cases.
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