Is your company successful in maximizing profits? A high pre-tax profit margin indicates a healthy company can achieve a good balance between increasing sales and lowering costs.
Investors and market analysts worldwide analyze pre-tax profit margins to value the viability of a venture. The pre-tax profit margin is good for internal use and illustrates operating efficiency. It can help you assess year-over-year organic growth, point out the red flags in your operation, and compare your company’s profitability with companies in the same industry.
What is the pre-tax margin?
Pre-tax profit margin, or EBT margin, is an operating efficiency financial ratio.
The pre-tax margin ratio tells you the % of sales you have turned into profits before taxes. High pre-tax profit margins are good indicators and vice versa.
How to calculate your pre-tax margin?
Using the pre-tax margin formula, you can easily calculate your pre-tax profit margin, as it requires only arithmetic operations.
Pretax margin formula
First, find the two required figures in your company financial statements, more precisely, in the income statement.
- EBT (earnings before taxes) represents your taxable revenue. It has accounted for all operating and non-operating expenses, including the interest expense, except for taxes. You can find it in the income statement as the final line before the tax expense and net income.
- Revenue is the top line of the income statement.
If the income statement doesn’t specify the company’s EBT, you can calculate it yourself for the pre-tax profit margin formula. You must add the taxes to your net income (NI).
Next, divide EBT (earnings before taxes) by revenue and multiply the result by 100 to get a result expressed in percentages.
Say you have an EBT of $20,000 and revenue of $100,000. Your pre-tax profit margin of 20% indicates you earn $0.20 in EBT from every $1 in revenues.
Importance of pre-tax profit margin
You can often find the pre-tax profit margins in your business financial statements because of their importance for third parties. The pre-tax margin ratio is beneficial because tax deductions might sometimes confuse investors.
First, analysts remove taxes from the equation since they offer minimal insight into a company’s efficiency. They are not in management’s control, and different states have different tax jurisdictions and tax rates.
For instance, you might have paid more taxes this year due to new legislation or a penalty. On the other hand, tax breaks, credits, and deductions might relieve your tax burden.
Calculating how many cents of profits you have earned from each dollar in sales before taxes allows for a fair representation of your company’s performance.
Drawbacks of pre-tax profit margin
While deducting taxes might prove useful for accessing organic growth, the pre-tax profit margin has certain limitations.
For instance, you cannot use the pre-tax profit margin to compare companies from different industries or diversified businesses catering to several industries. On the contrary, it’s best to use the EBT margin for comparing companies within the same sector and preferably within the same tax jurisdictions.
Each industry has specific sales and expense patterns, so it would be like ‘comparing apples and oranges.’
In addition, a company’s capital structure affects the pre-tax profit margin due to interest expenses. A company with higher debt will pay more interest than a company that primarily relies on equity. Consequently, debt financing leads to lower pre-tax profit.
How to interpret your pre-tax margin?
The pre-tax margin ratio shows how much profit your company generates from operations before tax expenses. A top-line ratio tells your company generates as much profit as possible. Simply put, the higher, the better.
Companies with higher pre-tax profit margins have greater pricing power and can incur greater tax expenses.
On the other hand, companies with lower profit margins are more dependent on a low-tax environment. In other words, higher tax rates can hurt their operation or, worse yet, lead to bankruptcy.
If your pre-tax profit margin has reduced from previous years, it means your business is doing worse.
What is a good pre-tax margin?
The profit margin ratio interpretation primarily depends on the industry. Generally, 10% is a healthy pre-tax profit margin, while 20% is high. Still, there’s no one-size-fits-all. So, it would be best to check your industry average.
What is a bad pre-tax margin?
Anything below your industry average indicates your business has a lower profit margin than your market competitors, either due to high financial leverage or poor management.
Anything below a 5% pre-tax profit margin should also concern you.
Pre-tax profit margin vs. other metrics
A standard layout income statement adheres to the following format:
- Gross Profit = Net Sales-COGS
- Operating Expenses
- Operating Income/EBIT (Earnings Before Income & Taxes) = Gross Profit-Operating Expenses
- Other Income & Expenses
- Income Taxes
- Net income = Pre-tax Profit-Income Taxes
Whereas operating expenses include:
- COGS (Cost of Goods Sold)
- SG&A (Selling, General and Administrative)
- R&D (Research and Development)
- S&M (Sales and Marketing)
And non-operating expenses include:
- Interest expense/interest income
- Gains/losses on sales
- Inventory write-downs / write-offs
You can get a few results depending on which lines of the income statement you decide to use. Fast forward, the pre-tax margin ratio differs from gross profit margin, operating profit margin, and net profit margin.
Gross profit margin
Your gross profit margin equals your gross profit divided by revenues multiplied by 100.
Gross Profit Margin= (Revenue - cogs)/Revenue x 100%
Gross profit equals revenue minus COGS but excludes other expenses from the equation.
It’s a good indicator of whether a company is achieving its industry benchmark. A business that wants to improve its gross profit margin should improve efficiency or raise prices.
Operating profit margin
Your operating profit margin equals your active income divided by sales multiplied by 100.
Operating Profit Margin = Operating Income / Revenue x 100%
Your operating profit will always be higher than your EBT (Earnings Before Taxes) and Net Income yet smaller than your Gross Profit.
It refers to net sales minus COGS, operating costs, and depreciation/amortization. However, it excludes other factors, such as your gains or losses from interest, investments, and taxes.
So, it’s a true indication of the viability of your internal processes. Therefore, it’s a better metric for valuing a business compared to other companies in the same industry than the pre-tax profit margin ratio.
Net profit margin
Your net profit margin equals your net income divided by sales multiplied by 100.
Net Profit Margin = (Revenue - cost)/Revenue x 100%
Your NI is the income statement’s bottom line; therefore, it’s the smallest number of all previously mentioned metrics.
It’s a good indicator for investors as it demonstrates the % of each dollar left of earnings for the shareholders after the government has taken its share. It can be used for comparison across all companies.
The pre-tax margin is an incredibly beneficial financial accounting tool when calculated correctly. As it factors out taxes, you can use it to measure your operational profitability and access organic growth.
Still, it would be best to combine it with other financial ratios to get the whole picture of your company’s health. You’ll be able to discover the reasons for fluctuations in your pre-tax profit margin, i.e., whether you are suffering from high financial leverage or internal or external activities.