How to Calculate Pre-tax
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Determining the financial status of your company goes beyond looking at earnings and deductions. There are other ways to demonstrate the status of your company that may not seem obvious at first, however a clearer picture begins to form when presenting your company at different stages of the fiscal year.
One of the stages you can present your company’s progress is by learning how to calculate pre-tax income. This can help with communication between clients and with your own financial planning throughout the year.
Read on to find out all about pre-tax income: what it is, how it can help you, and how to calculate your own pre-tax income.
How to calculate pre-tax in a nutshell
- Pre-tax is earnings before tax and refers to your annual income after expenses are lodged but before taxes are deducted
- Determing pre-tax income provides a clearer picture of your company’s financial situation
- Pre-tax income calculation can also be useful for assessing competition in the same industry and conducting internal analyses of your company’s performances year to year
- You can better understand the profitability of your business by doing a pre-tax calculation
- The effective tax rate is suitable for the majority of the population, while the marginal tax rate is suited for the minory of high earners in the highest tax brackets
- While pre-tax income calculation is useful for assessing competition in the same industry, it is less useful when comparing your company to others in different industries
What is pre-tax income?
Pre-tax income is often referred to as earnings before tax (or EBT). It refers to your annual income after expense deductions are lodged but before taxes are subtracted. Understanding how to calculate pre-tax income provides an important insight into the financial standing of your company.
Significance of pre-tax income
Like any financial review of your company, determining the pre-tax income will establish crucial aspects which you may not have thought to look into before. Create a fuller picture of your company’s status by calculating its pre-tax income to achieve the following:
- Insights into the financial standing
- Comparison between intercompany and intracompany
- Measurement of the company’s fiscal health
- Benefits for the profitability ratio
Provide insight into your company’s financial standing
Taxes will affect your company’s overall earnings and therefore provide a different report of its earnings. Paying taxes is deducting from your company’s earnings on necessary external things like insurance, commuting costs, equipment, etc. When you calculate your pre-tax income you present a clear picture of the worth of your company outside of these necessary deductions, making it an important income report.
Facilitate intercompany and intracompany comparisons
Intercompany comparisons are a comparison of competing businesses in the same market which benefit all companies involved by helping them better understand the nature of their competition. An intracompany comparison is an internal review and comparison of one company with its performance in the previous financial year.
Doing these comparisons after having calculated your pre-tax income gives a clearer picture of the competition because of how taxes complicate the procedure. Since taxes differ from region to region, sometimes quite considerably, conducting an intercompany comparison with a business in another country can potentially distort the competition due to different tax laws in the country.
Similarly with an intracompany comparison, new tax laws and fluctuations year to year will again distort the presentation of your company’s financial standing, thus making the comparison less clear than it would have been.
Help measure the fiscal health of your company
Measuring a company’s financial health takes assessing many different factors. Instead of looking at annual earnings and comparing them to last year, financial health requires more detailed assessments of annual fluctuations, changes in the market, and careful assessments of balance sheets.
Pre-tax income plays into this because your company’s fiscal health is more accurately represented prior to paying tax. Pre-tax, you understand the earnings and progress as unchanged by the inevitable fluctuating tax payments, and so you can plan better for the future.
Serve your profitability ratio
As a business owner, you can use profitability ratio metrics to assess your company’s ability to generate earnings relative to its revenue, using data from a certain point in time. In short, you can determine whether your company will be profitable over a length of time.
When you calculate your pre-tax income, you determine the amount your company is able to convert from revenue into profit. You can also determine the return on investment from stockholders (ROE) and how your company can use its assets to generate profit.
How to calculate pre-tax
This is the formula for calculating pre-tax income:
Pre-tax Income = Gross Revenue – Operating, Depreciation, and Interest Expenses + Interest Income
What is the pre-tax profit margin?
You can use the pre-tax profit margin to measure the operating efficiency of your company. The operating efficiency is the efficiency of profit earned as a function of your company’s operating costs. The pre-tax profit margin therefore will tell you the percentage of sales turned into profits. Put simply, it is a ratio which tells you the cents of profit per each dollar of sale before taxes. The pre-tax profit margin is often used to compare profitability with other companies in the same industry.
Effective vs marginal tax rate
Often a point of confusion for taxpayers, both rates can tell a lot about your financial profile. Which one you will use to calculate your tax rate depends on your income class.
Marginal tax rate
The marginal tax rate is favoured by high earners—the minority in the top tax bracket. To determine your marginal tax rate, you calculate the rate of tax charged on your last euro of income. So, if you are in the tax bracket of 25%, your euro of deductions will be worth 25c in tax you save.
Effective tax rate
A better method for the majority of the population, the effective tax rate is the percentage of taxes you pay on all taxable income. Determining the rate at which you pay taxes, for a business it is your rate of pre-tax profits.
What are the pros and cons of pre-tax income?
Some analysts argue that measuring profits after tax distorts the profit margin of a company and therefore offers poor insight. They claim that profit margin assessments after tax should be avoided entirely. This remains one of the strongest arguments for calculating your pre-tax income.
There are limitations to pre-tax profit margins, however. Because they are frequently used to compare companies in similar industries, the operating and expenses patterns of companies in different sectors may make them incompatible for a comparison. In this way, they are not a useful comparison tool if the companies are in different industries.
Example: pre-tax calculation
Let’s use a hypothetical example of your company’s earnings to help determine your pre-tax income:
Annual gross profit: €50,000
Operating expenses: €25,000
Interest expenses: €5,000
Sales: €250,000
You calculate the pre-tax earnings by subtracting operating and interest expenses from your gross profit:
€50,000 – €30,000 = €20,000
You then divide your pre-tax earnings and gross income:
€20,000 / €250,000 = 0.08
Leaving your pre-tax profit margin at 8%.
You can also use a pre-tax savings calculator to save time on the process.
Conclusion
Understanding the profitability and financial status of your company is benefited by an in depth analysis from many different angles. It is also important to understand which kinds of calculations will benefit your business in which way.
If you wish to compare your company’s status with competitors in the same industry, then learning how to calculate pre-tax income may be ideal. However, making comparisons with companies in other industries will cause complications and may require a different mode of assessment.
