Pretax Income (Earnings Before Taxes)

Pretax income is the net earnings of the business calculated after deducting all the expenses, including cash expenses like salary expenses, interest expenses, etc., as well as non-cash expenses like depreciation and other charges from the total income generated but before deducting the amount of income tax expense.

The name, pretax income, itself suggests that it is the income recorded after deducting all applicable amounts but before subtracting the taxes. This is the amount from which the taxes are deducted to derive the final income that one is subject to receive.

Pretax income is the amount derived after all income is added and all applicable deductions are made. The resulting amount is from where the taxes are subtracted further.

The figures obtained let individuals learn about their earnings before the taxes are taken away. On the other hand, for firms, these earnings help them get a comparable profit figure before the taxes are subtracted as the corporate taxes applicable differ from region to region and nation to nation. This means, the companies can make appropriate comparisons between their respective intrinsic profit amounts, before different tax percentages are applied to them.

When this pretax earning is known to firms, it helps them assess their financial performance before the taxes are subtracted from the actual profits that they have made, calculated after all deductions.

Analysts and Investors use Pretax Income to track the performance of businesses. It is an important profit metric tracker for avoiding the impact of taxation in different jurisdictions and tax rates. Earnings Before Tax are determined per the provisions laid down in Generally Accepted Accounting Principles (GAAP), which are uniform all over. Also, Earnings Before Tax is a more consistent measure of profit than Net Income. The latter gets impacted by tax credit, tax penalties, etc., making earnings more volatile and difficult to project for future years.

If the earnings after tax deductions are taken into consideration, the profit figures derived would not give an accurate, reliable profit figure as the tax deducted is different for different regions, states, and nations. However, if the amount before tax deductions is considered for computing figures, the profits are in raw form and hence, more reliable for performance assessment.

EBT is the penultimate item in the Income statement before adjustment of taxes is undertaken. We can compute it using various methods. Some of the popular formulas for the calculation of pretax Income are as follows:

Pretax Income formula = Gross Profit- Operating Expenses-Interest Expenses

Where Gross Profit =Net Sales- Cost of goods sold

Operating Expenses= General Administrative Expenses+ Selling and Distribution Expenses+ Depreciation

• EBT formula = Operating Income- Interest Expense
• Pretax Income formula = Profit After Tax (PAT)+ Tax Expenses
• Pretax Income formula = Revenues- Expenses (excluding Income Taxes)

Pretax Income (also called Earnings before Taxes) refers to the income earned by the business after adjusting for all operating expenses, including non-cash expenses such as Depreciation and finance charges such as Interest payments, but before deduction of taxes from Income. It acts as a good performance measure as it doesn’t consider the impact of taxes, which may vary for a different jurisdiction.

Let’s see how it relates to the Income Statement of the business:

With Earnings Before Tax, one can easily measure the performance of businesses operating in different geographical locations, duly adjusting for leverage but without getting the impact of the taxation rules of the said jurisdiction. Analysts across the globe prefer to use EBT as a yardstick for comparing the performance of various firms.

Let’s understand the concept of Pretax Income with the help of a few examples:

Example #1

Sackett Laboratories is in the business of making medicines. The company reported Total Revenues of $40000 during the year ended Dec 2017. The company incurred manufacturing expenses amounting to $28000 during the year in manufacturing medicines.

Following are the expenses of the company during the year:

Based on the above information, we can do the calculation of Pretax income using the formula (discussed above)

Pretax Income formula = Net Sales- Cost of goods sold-Operating Expenses.

Thus Sackett Laboratories made an Earnings Before Tax of $6200 during the year.

Example #2

Let’s understand the same with the help of another example of a large listed Company.

From the above screenshot, we can easily see how the company's pretax earnings have changed from 2000 to 2004 and can perform an analysis to measure Operational Efficiency.

Points worth noting based on the above analysis:

From 2000 to 2004 Revenues increased by 5.00% ( $86145 in 2000 to $104710 in 2004). However, Pretax Income has remained constant at 10% of revenues, and Net profit has remained constant at 6.5% year on year.

Thus Earnings Before Tax helps in understanding the Revenue growth and Profit growth in better terms and provides meaningful insights into comparing different businesses.

Obtaining the amount helps individual know the amount on which the tax will be applicable. This is the amount from which the tax is subtracted. Some of the advantages of this type of income are as follows:

• EBT helps compute the Effective Tax Rate of the business, which acts as an important yardstick for measuring the profitability of similar businesses operating in different jurisdictions. By analyzing the Effective Tax Rate, analysts can identify whether the business's income tax Expense report differs from the tax expense based on the statutory Income Tax rate. The same can be calculated as follows:

          Effective Tax Rate= Income Tax Expense/ Pretax Income

• It helps to easily compare the operational efficiency of different firms in the same industry in the same jurisdiction and a different jurisdiction.
• Earnings Before Tax helps better understand the revenues reported by the business. Comparing the Earnings Before Tax with the Revenues, one can understand whether sales are achieved by compromising business margins or through better pricing and business efficiency. Let's understand the same with a small example:

As evident from the above figures, Net Revenues grew from $35000 in 2016 to $50800 in 2018 and Pretax Income from $3000 in 2016 to $4000 in 2018. However, effective Margins fell from 8.57% in 2016 to 7.87% in 2018. Thus Earnings Before Tax helps in better.

An important point to note about Pretax Income and Taxable Income

If Taxable income is less than Pretax Income, and the cause of the difference is expected to reverse in future years, a Deferred Tax liability is created. Similarly, a Deferred Tax Asset is created if Taxable Income is greater than Earnings Before Tax, and the difference is expected to reverse in future years. It is important for Analysts and those tracking the business to consider the same while evaluating business performance.

Besides the merits, there are demerits too of obtaining these pretax earning figures. Let us check out the limitations as well below:

• It ignores the taxation effect and, as such, is not an ideal measure if somebody is planning to start a business as taxation is an important cash outflow and needs careful consideration.
• A certain business carries more taxes than others, such as Sin Tax and Higher Import Rates. Without a Taxation impact, a business decision might be influenced by that business, which carries high taxation rates.

When it comes to calculating the overall earnings of a business or individual, there are different types of income that are recorded. Sometimes, they are confusingly used as synonyms or substitutes for one another. Hence, it is important to know the differences between some of such terms.

Pretax income is often confused with net income, EBIT, and taxable income. Let us compare these terms below for a better and clearer understanding of them:

• As discussed above, pretax income is the earnings derived when all income is added and all deductions are applied to it except for taxes. On the other hand, when the taxes are subtracted from the pretax earnings, the amount obtained is the net income.
• Pretax earnings are the Earnings Before Taxes (EBT), i.e., the amount before the tax is subtracted from it. On the contrary, EBIT, which stands for Earnings Before Interests and Taxes, is the amount of income recorded before the interests and taxes are subtracted from the earnings, which has all other income added and deductions already applied to them. In short, when one subtracts the interest expense from EBIT, the amount derived is the pretax earnings.
• Pretax earnings are the figures from which the taxes are deducted, while taxable income is the amount of earnings after the taxes are deducted from it.

This article has been a Guide to what is Pretax Income (EBT). We explain the concept with its formula, how to calculate it, vs net income, vs EBIT, vs taxable income. You may learn more about financing from the following articles –

• OPEX Examples
• What is EBIT?
• EBITDA Overview