Welcome to the jungle102
EBIT doh!
I came back from the bar to nd Jerry had a le open in front
of him. It was stamped Golden Orchid – Private and Condential.
He pulled out a printout as ash tumbled from his cigarette. A
key fell from his trouser pocket. I recognised it as the key to his
ofce safe.
‘Why haven’t you left the key in your ofce?’ I asked.
‘No reason,’ he snapped back. ‘Pay attention. You need to
concentrate on EBIT.’
‘What’s that?’
‘It’s the earnings a company makes before it pays out interest or tax.
Sometimes it’s known as operating prot.’
‘Why?’
‘Because, brains, it’s the prot the company makes from its
operations. It hasn’t yet paid out any money to pay its debt and
it hasn’t yet paid any money out in the form of tax.’
‘So what?’
‘Is it National Thick Day today? I hope your love-life isn’t giving
you problems.’
I said nothing, Jerry took a pull on his new pint and continued.
‘It’s smart to assess a company before interest and tax distort its
operational performance. Look at Golden Orchid.’
Income statement Yen (m)
Turnover 180,000
Costs 2 60,000
EBIT 120,000
I did a quick mental calculation. At the operating level Golden
Orchid was incredibly protable. Its costs were only one-third
103Chinese walls come tumbling down
of its income. Its operating margin was 66.7 per cent (120,000
divided by 180,000), which was very wide.
‘Golden Orchid is currently nanced just by its shareholders. It
doesn’t have any borrowings. Is that a good or a bad thing?’
‘Good, I guess. They don’t have to pay any interest so there is
more prot.’
‘Wrong answer. We actually want Golden Orchid to pay interest
so it reduces prot.’
‘Why? Surely that makes the company more risky?’
Jerry smiled. ‘Welcome, young man, to the world of investment
banking.’ He ourished another spreadsheet. ‘This is Golden
Orchid at the moment. Take a glance and tell me what you see.’
Income statement Yen (m)
Turnover 180,000
Costs 2 60,000
EBIT 120,000
Interest paid 0
Profit before tax 120,000
Tax @ 25% 2 30,000
Profit after tax 90,000
Dividends paid 2 40,000
Profit retained 50,000
‘The company pays no interest, so its prot before tax is exactly
the same as its EBIT. It pays ¥30,000 in tax. It gives ¥40,000 to
shareholders and retains ¥50,000.’
‘Fine. Now look at my proposal. Instead of paying ¥40,000 to
shareholders we pay ¥40,000 to bondholders. What changes
because Golden Orchid has borrowed money?’
Welcome to the jungle104
Income statement Yen (m)
Turnover 180,000
Costs 260,000
EBIT 120,000
Interest paid 240,000
Profit before tax 80,000
Tax @ 25% 220,000
Profit after tax 60,000
Dividends paid 0
Profit retained 60,000
‘The prot is lower because Golden Orchid pays ¥40,000 in
interest. Prot before tax falls, and this means the tax is now
¥20,000 not ¥30,000.’
‘OK, I get that.’
‘Now here’s the clever bit. Look at the prot retained. It’s gone
up from ¥50,000 to ¥60,000. We’ve made an extra ¥10,000 prot
for the shareholders.’
‘How?’
‘The business at the operating level – which is what EBIT shows
– hasn’t changed at all. But Saiwai has created ¥10,000 of extra
value by changing the funding from equity to debt. Interest
expense is a cost of running the business. It’s a tax-deductible
expense, just like your pitiful salary or my huge bonus. Or even
the electricity and light we spend on keeping Perrine’s desk lit up.
By the way, how is it going with her?’
I marvelled at just how quickly ofce gossip spreads. It seemed
that even people who couldn’t stand the sight of each other
spent whole lunchtimes dissecting my love-life. Or lack of it.
Jerry continued. ‘It’s quite common for private equity funds to
take over the running of a business, put in new management
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