Pretax Margin Ratio
Measuring a company's operational profitability in a tax-free setting
What is the Pretax Margin Ratio?
The Pretax Margin Ratio, also knows at the Earnings Before Tax (EBT) ratio, is an operating profitability ratio used by market analysts and investors. This ratio is useful in analyzing the standalone profitability of a company’s operations, as it excludes tax expense. The pretax margin ratio is also useful in assessing the year-over-year organic growth that a company experiences, as it focuses on the intrinsic value that the business generates.
How can we calculate the Pretax Margin Ratio?
The ratio can be calculated using the following equation:
Where:
Earnings Before Taxes (EBT) = Net Income + Taxes (EBT can sometimes be found on the income statement)
Sales = Sales revenues recorded in the accounting period
A higher ratio indicates a company with a high degree of operational profitability. A lower ratio indicates poorer operational profitability. This means that the company is more dependent on a low-tax environment to ensure profitability.
The thinking behind using this ratio is that a company’s earnings growth should not be artificially penalized by high tax rates. The pretax margin ratio more clearly reveals how a company’s operations are actually performing. Also, a company’s operational profitability relative to a competitor may be overstated if the competitor operates in a higher tax environment. Thus, using the pretax margin ratio factors out extraneous tax effects on a company’s performance.
Pretax Margin Ratio Example
Jake’s Bakery just filed its financial statements for the current accounting year. Below is a simplified version of Jakes’ income statement for the past four years:
The red boxes highlight the company’s net revenue, earnings before taxes, and income tax expenses. These figures are relevant to the calculation of the pretax margin ratio. Using the formula explained earlier, we get the following ratios:
Looking at the numbers above, we can see that the bakery’s operational profitability slowly dropped each year from 2015-2018. While we also see that the company’s EBT is slowly declining, its total revenue is increasing year over year. This may indicate that the company’s expenses are growing faster than its revenues, meaning that the bakery’s future profitability may be in danger.
When using the pretax margin ratio, it is important to compare it against the ratios of competitors in the industry in order to draw additional insights. For instance, the rise in expenses that the bakery faces may be due to industry factors such as increasing costs of raw materials. This will negatively affect all companies in the industry.
Additional Resources
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following CFI resources:
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