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What’s it: NOPAT margin is a profitability ratio to measure how efficiently a company generates profit from its core business after accounting for expenses paid as taxes. We calculate it by dividing NOPAT by revenue. We use it as an alternative to other profit margins such as EBIT margin, EBITDA margin, or net profit margin.
NOPAT is a profit return from a core business operation. It represents how much profit is available from day-to-day operations after accounting for the tax burden. Because we compare it to revenue, we take the NOPAT margin as how efficiently the company generates those profits. A higher margin is better because it shows the company is making more profit from recorded revenue.
How to calculate NOPAT margin?
To calculate the NOPAT margin, we must first obtain NOPAT- stands for net operating profit after tax. Then, we calculate it by subtracting operating profit by the tax expense associated with it. Alternatively, we multiply operating profit by (1- tax rate).
- NOPAT = Operating profit x (1 โ Tax rate)
In some companies, the income statement may present operating profit figures as a separate account. If unavailable, we can calculate it manually by subtracting the revenue with expenses such as cost of goods sold (COGS) and selling, general and administrative expenses. We exclude interest expense because it is a non-operating item.
After getting NOPAT, we divide it by revenue to get the margin. Here is the NOPAT margin formula:
- NOPAT Margin = NOPAT / Revenue
For example, suppose a company posted revenues of $4 million and operating expenses of $3 million. If the company bears a tax rate of 15%, then its NOPAT equals $850,000 = ($4 million – $3 million) * (1 – 15%). Meanwhile, NOPAT margin equals 21.3% = 850,000 / $4 million. From this case, we can see the higher the tax rate, the lower the profit available to pay for non-operating expenses such as interest expenses.
How to interpret the NOPAT margin?
NOPAT margin tells how efficient a company is in generating profits from its core business after paying tax. The higher it is, the better, indicating a profitable core business.
On the other hand, a lower margin is less desirable because the company’s operations appear unprofitable. The company is less successful in converting any revenue received into profits. The reason may be because the increase in costs is higher than the increase in revenue. Or, the company posted lower revenues but unchanged operating costs.
Several reasons why NOPAT margins are rising:
- It could be because the company is posting revenue at lower costs, for example, by achieving higher economies of scale.
- The company generates more revenue by maintaining existing costs, for example, by increasing selling prices.
- The tax burden is lower, for example, by operating in countries with lower taxes, such as developing countries.
Why use NOPAT margins?
NOPAT margin is important in analyzing a company’s financial soundness. For example, we can relate it to its success in competing in the market and efficiency in managing costs. Or, compared to other profit metrics, it is more stable and reflects its financial cushion.
Metrics for efficiency in core business
NOPAT margin expresses how successful the company is in converting revenue into profit in its core business. Analysts and investors like it when companies make profits from operations instead of non-operations.
Take food companies as an example. Their success in running a business is measured by how many dollars they make selling the product and how much it costs, not by how much they save from debt burden or how much interest income they earn from investing cash. Interest is not part of their core operation.
A higher margin can also indicate the company successfully competes in the market and controls operating costs. But, of course, it requires further investigation.
If margins are higher than competitors’ averages, it may come from a strong market position. Thus, companies can sell more products and earn higher profit margins per unit than their competitors.
In addition, a competitive market position can also support efficiency. For example, it gives the company greater bargaining power over suppliers, enabling it to obtain inputs at lower costs. In addition, by selling more, companies can achieve higher economies of scale.
Exclude volatile non-operating items
NOPAT is more stable than indicators such as net income because it excludes non-operating items. Often, non-operating items appear once with significant value. As a result, net income will be more volatile. But, that’s not with NOPAT, as it excludes them from the calculation.
For example, the company posted a gain from the translation of the exchange rate this year with a fairly large value. But, that may not be the case in the next year. In fact, the company may record a translation loss. Thus, it affects net income but not with NOPAT.
Considering tax liability
NOPAT takes into account taxes to be paid; it is different from profit metrics like EBIT or EBITDA. We exclude the tax burden when calculating both.
Excluding taxes from the calculation can be misleading when measuring the actual profits generated. That’s because taxes become routine expenses such as interest expenses. Moreover, the company must pay taxes and cannot refuse them.
In addition, how much tariffs must be paid is beyond the control of management but is determined by law. So, for example, the government imposes higher tax rates. And the NOPAT figure takes into account the change, not with EBIT or EBITDA.
Then, suppose depreciation and amortization expenses are low. In that case, NOPAT can be a useful metric to measure the recorded cash from the core business because it already takes into account the cash the company has to spend to pay taxes. And we can use it as an alternative to EBITDA.
