Pretax Profit Margin

The pretax profit margin is a financial accounting tool used to measure the operating efficiency of a company. It is a ratio that tells us the percentage of sales that has turned into profits or, in other words, how many cents of profit the business has generated for each dollar of sale before deducting taxes. The pretax profit margin is widely used to compare the profitability of businesses within the same industry.

Companies across the globe strive to generate as much profit as possible. For investors, one of the most common and useful measures to gauge corporate profitability is to look at profit margins. Consistently high pretax profit margins are a sign of a healthy company with an efficient business model and pricing power. Low pretax profit margins suggest the opposite.

To boost profitability, management teams must strike a balance between increasing sales and reducing costs. Pretax profit margins give us an indicator of how successful companies are at achieving this goal. As a result, they are closely watched by analysts and investors and frequently referred to in financial statements.

Pretax profit margin only requires two pieces of information from the income statement: revenues and income before taxes. The percentage ratio is calculated by deducting all expenses except for taxes, found in the income before taxes figure, dividing it by sales and then multiplying the resulting number by 100.

Alternatively, the pretax profit margin can be calculated by adding taxes back to net income (NI) or by dividing net income by '1 minus the effective tax-rate' and then dividing by sales.

Company EZ Supply has an annual gross profit of $100,000. It has operating expenses of $50,000, interest expenses of $10,000, and sales totaling $500,000. The calculation of earnings before taxes is from subtracting the operating and interest costs from the gross profit ($100,000 - $60,000). EZ Supply has pretax earnings of $40,000, and total sales of $500,000 for the given fiscal year (FY). The pretax profit margin is calculated by dividing pretax earnings by sales, resulting in a ratio of 8%.

The pretax profit margin offers investors one of the best ways to compare competing companies, as well as those with significant differences in size and scale, in the same industry. Often, profit margins after taxes gains more prominence among analysts and investors. However, it can be argued that tax payments offer little insight into the efficiency of companies and should, therefore, be stripped out of the equation.

Tax expenditures can make profitability comparisons between companies misleading. Tax rates vary from state to state, are generally out of management’s control and aren’t necessarily a fair reflection of how a business is performing.

At times, the tax expense can be more substantial in a current year than in previous years due to tax penalties and new legislation imposing higher tax rates. Alternatively, the present tax expense may be much lower than it had been in earlier years due to tax credits, deductions, and tax breaks. In this case, analysts may be able to decrease earnings volatility by calculating the pretax profit margin.

Though very insightful, pretax profit margins, like other financial ratios, have limitations. For one, they cannot be used effectively to compare companies from other sectors as each industry generally has different operating expenses and sales patterns.

Certain sectors are more profitable than others. Legal services is an example of a high margin profession. Overheads are low — there’s little need for big investment costs, other than salaries — and demand is fairly constant. In contrast, other sectors, such as airlines, have to deal with stiff competition, fluctuating prices for key materials such as fuel, hefty maintenance expenses, and countless other costs. For this same reason, investors should also be cautious about using pretax profit margins when comparing diversified companies serving several industries.

When used correctly, pretax profit margins can provide a useful gauge of business efficiency. However, to get a complete grasp of a company’s health, investors are always advised to use the pretax profit margin in tandem with other metrics. The more you know about a company the better you can establish whether it is worth investing in.