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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 analysts to evaluate the profitability of a company. The ratio is useful in analyzing the standalone profitability of a company’s operations, as it excludes the tax expense that it faces from the profitability assessment. The pretax margin ratio is also useful in assessing the year-over-year organic growth that a company also experiences, as it focuses on the intrinsic value that the business generates.

 

Pretax Margin Ratio

 

How can we calculate the Pretax Margin Ratio?

The Pretax Margin Ratio can be calculated using the following equation:

 

Pretax Margin Ratio Formula

 

Where:

Earnings Before Taxes (EBT) Net Income + Taxes (EBT can sometimes be found on an income statement)

Sales = Sales revenues recorded in the accounting period

A higher pretax margin ratio would be indicative of a company with a high degree of operational profitability, whereas a lower ratio would indicate poorer operational profitability (i.e., higher reliance on a low-tax environment to showcase profitability).

The thinking behind the ratio is that a company’s earnings growth should not be artificially penalized by high tax rates (assuming a high-tax environment), but rather assessed based on how its operations are actually performing. Conversely, in a lower-tax environment, a company’s operational profitability may be overstated when comparing it to a competitor operating in a higher-tax environment. Thus, using the pretax margin ratio to assess operational profitability will factor out extraneous tax factors and focus on how the company’s operations are performing.

 

Pretax Margin Ratio Example

Jake’s Bakery currently just filed its financial statements for the business’ current accounting year. Below is a simplified version of Jakes’ income statement for the past four years:

 

Pretax Margin Ratio Example

 

The red boxes highlight the company’s net revenue, earnings before taxes and income tax expenses; which are relevant to the calculation of the ratio. Using the formula explained earlier, we get the following pretax margin ratios:

 

Pretax Margin Ratio

 

Looking at the numbers above, we can see that the bakery’s operational profitability slowly dropped each year before reaching a low of 3.25% in 2018. While we also see that the company’s EBT is slowly declining, its total revenue is increasing year over year. It may indicate that the company’s expenses are growing faster than its revenues, meaning that the bakery’s future profitability may be in danger.

However, when using the ratio, it is also important to compare it against the pretax margin 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 certain industry factors such as the increasing costs of raw materials, which will negatively affect all companies in the industry. In such cases, we cannot tie the loss of profitability to Jake’s Bakery in particular since all companies will be affected.

 

Additional Resources

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