Pretax income is the net earnings of the business calculated after deducting all the expenses including cash expenses like salary expense, interest expense, etc. as well as non- cash expenses like depreciation and other charges from the total income generated but before deducting the amount income tax expense.
What is Pretax Income (Earnings Before Taxes)?
Pretax Income (also called as Earnings before Taxes) refer to the income earned by the business after adjusting for all operating expenses including non-cash expenses such as Depreciation and finance charges such as Interest payments but before deduction of taxes from Income. It acts as a good performance measure as it doesn’t take into consideration the impact of taxes which may vary for a different jurisdiction.
Let’s see how it relates to Income Statement of the business:
With Earnings Before Tax, one can easily measure the performance of businesses operating in different geographical locations, duly adjusting for leverage as well but without getting impacted by the taxation rules of the said jurisdiction. Analysts across the globe prefer to use EBT as a yardstick for comparing the performance of various firms.
Pretax Income Formula
EBT is the penultimate item in the Income statement before adjustment of taxes is undertaken and can be computed using various methods. Some of the popular formulas for the calculation of Pretax Income are as follows:
Pretax Income formula = Gross Profit- Operating Expenses-Interest Expenses
Where Gross Profit =Net Sales- Cost of goods sold
Operating Expenses= General Administrative Expenses+ Selling and Distribution Expenses+ Depreciation
- EBT formula = Operating Income- Interest Expense
- Pretax Income formula = Profit After Tax (PAT)+ Tax Expenses
- Pretax Income formula = Revenues- Expenses (excluding Income Taxes)
Examples of Pretax Income
Let’s understand the concept of Pretax Income with the help of a few examples:
Sackett Laboratories is in the business of making medicines. The company reported Total Revenues of $40000 during the year ended Dec 2017. The company incurred the manufacturing expenses amounting to $28000 during the year in the manufacturing of medicines.
Following are the expenses incurred by the company during the year:
Based on the above information we can do the calculation of Pretax income using the formula (discussed above)
Pretax Income formula = Net Sales- Cost of goods sold-Operating Expenses
Thus Sackett Laboratories made an Earnings Before Tax of $6200 during the year.
Let’s understand the same with help of another example of a large listed Company.
From the above screenshot, we can easily see how the Pretax Earnings of the company has changed over the year 2000 to 2004 and can perform analysis to measure Operational Efficiency.
Points worth noting based on the above analysis:
From 2000 to 2004 Revenues increased by 5.00% ( $86145 in 2000 to $104710 in 2004), however, Pretax Income has remained constant at 10% of revenues and Net profit has remained constant at 6.5% year on year.
Thus Earnings Before Tax helps in understanding the Revenue growth and Profit growth in better terms and provides meaningful insights in comparing different business.
- EBT helps in the computation of the Effective Tax Rate of the business which acts as an important yardstick for measuring the profitability of similar businesses operating in different jurisdictions. By analyzing the Effective Tax Rate analysts can identify whether the Income Tax Expense report by the business differ from the tax expense based on the statutory Income Tax rate The same can be calculated as follows:
Effective Tax Rate= Income Tax Expense/ Pretax Income
- It helps in easy comparison of the operational efficiency of different firms in the same industry in the same jurisdiction and also in a different jurisdiction.
- Earnings Before Tax helps in a better understanding of the revenues reported by the business. By comparing the Earnings Before Tax with the Revenues, one can understand whether sales are achieved by compromising with business margins or through better pricing and business efficiency. Let’s understand the same with a small example:
As evidenced from the above figures Net Revenues have grown from $35000 in 2016 to $50800 in 2018 and Pretax Income has grown from $3000 in 2016 to $4000 in 2018, however effectively Margins have fallen from 8.57% in 2016 to 7.87% in 2018. Thus Earnings Before Tax helps in better
Important point to note about Pretax Income and Taxable Income
If Taxable income is less than Pretax Income and the cause of the difference is expected to reverse in future years, a Deferred Tax liability is created. Similarly, if Taxable Income is greater than Earnings Before Tax and the difference is expected to reverse in future years, a Deferred Tax Asset is created. It is important for Analysts and those tracking the business to take the same into consideration while evaluating business performance.
- It ignores taxation effect and as such is not an ideal measure if somebody is planning to start a business as taxation is an important cash outflow and needs careful consideration.
- A certain business carries more tax compared to other businesses such as Sin Tax, Higher Import Rates. In the absence of Taxation impact, a business decision might be influenced towards that business which carries high taxation rates.
Pretax Income is used by Analyst and Investors to track the performance of businesses and it is an important profit metric tracker which avoids the impact of taxation associated with a different jurisdiction and tax rates. Earnings Before Tax is determined as per the provisions laid down in Generally Accepted Accounting Principles (GAAP) which are uniform all over. Also, Earnings Before Tax is a more consistent measure of profit than Net Income which gets impacted by a tax credit, tax penalties etc making earnings more volatile and difficult to project for future years.
This has been a guide to what is Pretax Income (EBT). Here we discuss Earnings Before Tax formulas used to calculate Pretax Income along with practical examples. You may learn more about financing from the following articles –