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 Earnings before Taxes) refers to the income earned by the business after adjusting for all operating expenses, including non-cash expensesNon-cash ExpensesNon-cash expenses are those expenses recorded in the firm's income statement for the period under consideration; such costs are not paid or dealt with in cash by the firm. It involves expenses such as depreciation. 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:Income Statement Of The Business:The income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.
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 the impact of 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. We can compute it 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 ProfitGross ProfitGross Profit shows the earnings of the business entity from its core business activity i.e. the profit of the company that is arrived after deducting all the direct expenses like raw material cost, labor cost, etc. from the direct income generated from the sale of its goods and services. =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 of 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 the 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 RateEffective Tax RateEffective tax rate determines the average taxation rate for a corporation or an individual. For both, there is a similar formula only with variation in considering variables. The effective tax rate formula for corporation = Total tax expense / EBT 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 reportExpense ReportAn expense report refers to a form served for requesting reimbursement or disclosing all the monthly, quarterly or yearly spendings an employee does on the company's behalf. In most cases, the expense receipts are also attached with it for evidence. 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 an 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 evident from the above figures, Net RevenuesNet RevenuesNet revenue refers to a company's sales realization acquired after deducting all the directly related selling expenses such as discount, return and other such costs from the gross sales revenue it generated. grew from $35000 in 2016 to $50800 in 2018 and Pretax Income from $3000 in 2016 to $4000 in 2018. However, effective Margins fell from 8.57% in 2016 to 7.87% in 2018. Thus Earnings Before Tax helps in better
An 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 AssetDeferred Tax AssetA deferred tax asset is an asset to the Company that usually arises when either the Company has overpaid taxes or paid advance tax. Such taxes are recorded as an asset on the balance sheet and are eventually paid back to the Company or deducted from future taxes. 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 a Taxation impact, a business decision might be influenced by that business, which carries high taxation rates.
Analysts and Investors use Pretax Income to track the performance of businesses. It is an important profit metric tracker for avoiding the impact of taxation of different jurisdictions and tax rates. Earnings Before Tax is determined as per the provisions laid down in Generally Accepted Accounting Principles (GAAP)Generally Accepted Accounting Principles (GAAP)Generally accepted accounting principles (GAAP) are the minimum standards and uniform guidelines for the accounting and reporting. These standards prohibit firms from engaging in unethical business activities and enable for a more accurate comparison of financial reports to investors., which are uniform all over. Also, Earnings Before Tax is a more consistent measure of profit than Net Income. The latter gets impacted by tax credit, tax penalties, etc. making earnings more volatile and difficult to project for future years.
This article 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 –