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What’s it: Pretax profit margin is a profitability ratio to measure how successfully a company converts revenue into profit before part of it is paid out as tax. We calculate it by dividing profit before tax (pretax profit) divided by revenue. Pretax profit margin is also called pretax margin, pretax income margin, earning before tax margin (EBT margin).
This ratio tells us how profitable the company’s business is. The higher the ratio, the better because the company generates more profit for each recorded revenue.
Why is pretax profit margin important?
The company strives to make as much profit as possible. It requires them to maximize sales and minimize costs. And the pretax margin tells us how successful the company is in achieving this goal, maximizing profits.
Stable or consistently rising margins signal a healthy company. This is because the company posted revenue at a more efficient cost. For example, the company has better market and pricing power, allowing it to earn more dollars. At the same time, companies operate more efficiently to earn these revenues, resulting in lower costs.
How to calculate pretax profit margin?
Calculating the pretax profit margin is easy because it only requires arithmetic operations. In addition, the figures are also available on the income statement. The calculation requires us to divide pretax profit by revenue.
Pretax profit can be found at the bottom, precisely above the tax expense account. It represents profit after the company covers operating and non-operating expenses, including interest expenses, before being paid as taxes. So, first, we calculate it by subtracting gross profit by operating expenses, and then, we add the result with non-operating profit (loss).
- Pretax profit margin = Pretax profit / Revenue
For example, a company reports pretax profit of $2,000 and revenue of $20,000. Applying the above formula, we get a pretax profit margin equal to 10% = ($2,000 / $20,000) x 100%.
How to interpret pretax profit margin?
Pretax profit margin measures how profitable a company’s business is. And the higher margin is preferable because it shows the company is making more profit from its business.
On the other hand, low margins indicate poorer profitability. As a result, companies may rely more on a low tax environment to ensure profits.
We can evaluate this margin from time to time to understand whether the company’s profits are improving or decreasing. In addition, using it in conjunction with other financial ratios helps us explore the reasons for the increase or decrease in margins, including whether it comes from operational or non-operational activities or whether it is due to low or high financial leverage.
Then, comparing this ratio to the industry average is equally important. We can measure how well a company is performing compared to its competitors. The increase or decrease in margin can occur due to internal or external factors. We expect internal factors to play a bigger role because they indicate better management.
Reviewing operational vs. non-operational components
Ideally, non-operating profit is relatively small compared to operating profit. It shows the company is successful in managing its core business.
Operating profit comes from daily activities. Revenues and expenses are recurring over time, so they can go up and down, depending on how successfully management manages its operations.
In contrast, non-operating profit is non-recurring. Its items can increase significantly in the previous year but not continue in the coming year. In other words, the trend can be very volatile.
Take the sale of assets by a manufacturing company as an example. It is a non-operational item. That could lead to a spike in pretax profit margins because of their significant value. But, because the company does not report it again in the next period, the margin can suddenly fall.
Thus, when analyzing the pretax profit margin, we must evaluate whether it comes from operating or non-operating. If there is an increase in non-operating profit, will it continue in the future?
Interest income is another example of a non-operating item. Unlike the proceeds from asset sales, it is relatively stable over time. Depending on how much cash the company invests, the balance often does not change drastically over time.
Checking company leverage
Pretax profit is sensitive to financial leverage, as is the margin. That’s because when we calculate it, we have deducted the interest expense.
What is leverage? Leverage tells us how dependent a company is on debt to finance its business.
Companies with high debt have high-interest expenses, resulting in lower pretax profits and margins. In contrast, companies with low debt have the opposite consequence.
Compared to the industry average
We need to compare this ratio against competitors or industry averages. It will provide a more objective insight into the company’s performance. For example, we can answer whether the company’s success in generating profits is due to favorable internal or external factors.
Companies in the same industry will face the same threats and opportunities in the business environment. For example, the market faces tougher competition and rising raw material prices. As a result, profit margins fall for all firms in the industry.
Even if margins decline due to external factors, a company may report better results than its competitors. These companies earn slightly higher margins than their competitors, performing better than their competitors. The company may earn higher revenues, manage the business more efficiently, or combine the two.
And in general, higher margins can come from:
- A strong market position lets the company generate more sales or charge higher prices without reducing demand.
- Better bargaining power with suppliers allows the firm to obtain inputs at lower costs.
- Better control of operating costs, so the company operates more efficiently.
What are the drawbacks of this ratio?
Pretax profit margin does not take into account the tax burden. Thus, it can be misleading in providing insight into a company’s profitability.
The tax burden can vary between companies. And it can have a material impact because the tax is beyond management’s control, has a fairly large nominal, and must be paid.
Some companies may report higher margins than their competitors because they operate in areas with low tax rates. Thus, their tax burden is also relatively low.
On the other hand, competitors may operate in countries with higher taxes. Their tax burdens increase as these countries introduce new tax laws and set higher tax rates.
Because of these variations in tax rates, excluding taxes can provide an unfair perspective when evaluating business performance. For example, a company may appear profitable because it bears a low tax burden, even though it is poor at generating profits from core business operations.
