What is Pre-Tax Income?
Pre-Tax Income (EBT) refers to the remaining earnings once all operating and non-operating expenses, except for taxes, have been accounted for.
- What is the definition of pre-tax income?
- How can the pre-tax income be calculated?
- Is pre-tax income and earnings before taxes (EBT) interchangeable terms?
- Which expenses are included in pre-tax income?
Table of Contents
How to Calculate Pre-Tax Income
The pre-tax income line item, often used interchangeably with earnings before taxes (EBT), represents a company’s taxable income.
By the time you reach the pre-tax line item, the starting line item of the income statement – i.e., the company’s revenue in the period – has been adjusted for:
- Cost of Goods Sold (COGS)
- Operating Expenses (OpEx)
- Non-Core Income/Expense (e.g. Interest Expense, Interest Income)
Therefore, interest expense and other non-core income or expenses must be subtracted from operating income (EBIT) to calculate the pre-tax income.
Pre-Tax Income Formula
- Pre-Tax Income = EBIT – Interest Expense
“Pre-tax” means that all income and expenses have been accounted for, except for taxes.
Thus, pre-tax income measures a company’s profitability before accounting for any tax impact.
Once taxes are deducted from a company’s pre-tax income, you have arrived at net income (i.e. the “bottom line”).
Conversely, if given the net income value, the pre-tax income can be calculated by adding back the tax expense.
Apple Example – Earnings Before Taxes (EBT)
Apple Pre-Tax Income (Source: AAPL 2021 10-K)
Pre-Tax Profit Margin
The pre-tax profit margin (or “EBT margin”) represents the percentage of profits a company retains prior to paying mandatory taxes to the state and/or federal government.
EBT Margin Formula
- EBT Margin = Pre-Tax Income ÷ Revenue
To convert the result into percentage form, the resulting amount from the formula above must be multiplied by 100.
Pros/Cons of Pre-Tax Income
Since pre-tax income excludes taxes, the metric makes comparisons among companies with different tax rates more practical.
For instance, the profitability of companies can deviate largely due to their geographic location, where corporate taxes could differ, as well as due to differing tax rates at the state level.
The company could also have items such as tax credits and net operating losses (NOLs) that can affect its effective tax rate – which further makes comparisons of comparable companies’ net incomes less accurate.
In the context of relative valuation, the primary limitation to pre-tax income is that the metric is still affected by discretionary financing decisions.
Despite the removal of tax differences, the EBT metric is still skewed by different capitalizations (i.e. interest expense) within the peer group, so a company could show higher profits than a peer due to not having any debt or associated interest expense.
The pre-tax income metric is most commonly used for calculating the taxes paid, rather than for peer comparisons.
Effective vs. Marginal Tax Rate
For purposes of building projection models, the tax rate can either be the:
- Effective Tax Rate (or)
- Marginal Tax Rate
The effective tax rate represents the percentage of a company’s taxes paid relative to its taxable income (EBT).
The effective tax rate for historical periods can be calculated by dividing the taxes paid by the pre-tax income (or earnings before tax), as shown below.
Effective Tax Rate Formula
- Effective Tax Rate % = Taxes Paid ÷ EBT
On the other hand, the marginal tax rate is the taxation percentage on the last dollar of a company’s taxable income.
The amount in taxes due largely depends on the statutory tax rate of the governing jurisdiction, not just the company’s taxable income – i.e. the tax rate adjusts based on the tax bracket the company falls under.
The effective and marginal tax rates differ because the effective tax rate uses pre-tax income (EBT) from the income statement, which is calculated under accrual accounting standards.
Since there can be differences between the pre-tax income on the income statement and the taxable income reported on tax filing, the tax rates are more often than not different.
But in either case, the tax rate is multiplied by the pre-tax profit to arrive at the net income line item.
Pre-Tax Income Calculator – Excel Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Pre-Tax Income Example Calculation
For our illustrative scenario, suppose we’re calculating a company’s pre-tax profit with the following financial profile.
- Revenue = $100 million
- COGS = $50 million
- Operating Expenses = $20 million
- Interest Expense, net = $5 million
Using the assumptions provided, the gross profit is $50 million, whereas the operating income (EBIT) is $30 million.
Next, the pre-tax income is equal to EBIT minus the interest expense.
- Pre-Tax Income = $30 million – $5 million = $25 million
The pre-tax profit margin can be calculated by dividing the EBT by revenue.
- Pre-Tax Margin = $25 million ÷ $100 million = 25%
From there, the final step before arriving at net income is to multiply the pre-tax income by the 30% tax rate assumption – which comes out to $18 million.