What is Pretax Income?
Pretax income, also known as earnings before tax, is the net income earned by a business before taxes are subtracted/accounted for. Pretax income, however, accounts for deductions related to operating expenses, depreciation, and interest expenses.
Formula for Pretax Income
The formula for calculating pretax income is as follows:
Pretax Income = Gross Revenue – Operating, Depreciation, and Interest Expenses + Interest Income
- Gross revenue: All revenues generated by the business
- Operating expenses: Includes deductions due to depreciation, amortization, and interest expenses
- Interest income: Revenues generated by the business from outstanding loans issued by the business
Consider Company ABC’s performance in 2018:
- Gross revenue: $8,000,000
- Cost of Goods Sold (COGS): $560,000
- Employee wages and salaries: $86,000
- Repair and maintenance costs: $12,000
- General administrative expenses: $240,000
- Interest expenses: $57,000
- Depreciation and amortization: $130,000
Using the formula above, the pretax income of Company ABC is calculated as:
Pretax Income = $8,000,000 – ($560,000 + $86,000 + $12,000 + $240,000 + $130,000 + $57,000) + 0
Pretax Income = $6,915,000
Significance of Pretax Income
1. Provides insight into a company’s financial standing
Taxes affect the overall earnings of a company. Pretax earnings, hence, provide an insight into the company’s financial performance and standing before its tax expense affects the net earnings and brings about any fluctuations.
2. Facilitates smooth, bias-free inter-company and intra-company comparisons
When performing an inter-company or an intra-company financial analysis or comparison, the year-by-year tax expense of an organization is noticeably volatile. This is because it depends not only on the yearly level of its earnings, but also depends on the tax slabs or tax rates which differ from one country to another, or even from one province to another.
An assessment of pretax income, as opposed to net earnings after tax, facilitates a much smoother and bias-free comparison of the organization over time, as well as a comparison to other companies. Looking at pretax income eliminates any discrepancies or effects that a tax expense could leave on an organization’s earnings.
3. Helps measures the fiscal health of a company over time
Another significance of pretax earnings is that it helps provide a more consistent and firm measure of the overall financial performance and fiscal health of a company over time. Pretax earnings eliminate the volatile differences that arise when tax considerations are accounted for.
4. Serves as a profitability ratio
Pretax earnings also help to accurately assess the profitability of a company. The pretax earnings margin is the ratio of a company’s pretax earnings to its total sales. The higher the ratio, the more profitable the position of the company. Using the information provided above, the pretax earnings margin for Company ABC is $6,915,000 / $8,000,000 (Pretax Earnings/Total Sales) = 87%.
Position on the Income Statement
On the income statement of an organization, pretax earnings are shown right before the calculation of the final net profit or net earnings of a company. The figure is shown as Earnings Before Taxes or Profit Before Taxes.
Pretax Income vs. Earnings Before Interest and Taxes (EBIT)
Earnings Before Interest and Tax (EBIT) refers to the net earnings of a company before accounting for any interest and tax expenses, whereas Earnings before Tax (EBT) refers to the net earnings of a company after accounting for all operating, depreciation, and interest expenses and interest incomes, but before accounting for any tax expenses.
Confusion often arises between the two terms. The main difference between them relates to interest expenses. EBIT is before the deduction of interest expenses and taxes, whereas EBT is after the deduction of all interest expenses and adding of all interest incomes to the operating income of a company.
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