Updated July 13, 2023
Definition of Pretax Income
Earnings before tax or Pre-tax Profits or Profits before tax are the company’s income after adjusting all the incomes, expenses, losses, depreciation, and interests but before deducting taxes. Pre-tax profits show the profitability of the company without the impact of the taxes. In this topic, we are going to see more about Pretax Income.
Explanation
Pre-tax profit or Profit before tax can be found on the company’s income statement and represents a company’s income after all the expenses have been deducted before income tax has been subtracted. Therefore, profit before tax provides a better picture of the company’s profitability than profit after tax.
The Formula for Pre-tax Income
Pre-tax profits are calculated as follows:
How to Calculate Pretax Income?
Step 1: Calculating Revenue: This item shows the income the business generates from selling its goods or rendering services. Earnings from the actual business of the entity are shown here. Other income, like interest, commission, etc., is also added under this head.
Step 2: Calculating Expenses: It includes various expenses incurred by the company in the course of its business:
- COGS (Cost of Goods sold): The cost of goods sold is the cost incurred in producing the goods the seller sells. It includes Material, Labor, and other costs directly associated with producing the goods.
- Operating expenses: Operating expenses are not directly related to the production of goods but are essential in keeping the business running. Administrative expenses, selling and distribution expenses, and salary expenses are some of the operating expenses incurred by a business.
- Interest Cost: Finance costs include the interest paid by the business on the loans taken from the bank.
Step 3: Calculating Pre-tax Income: In this final step, deduct the entire expense total from the revenue total to get the pre-tax Income figure.
There are other formulas to calculate Earnings before tax from the Income statement under various situations:
Examples of Pre Tax Income
Examples of pre-tax income are given below:
Example #1
ABC Ltd prepares its income statement for the year ended 2018-19. Below are the details of the various incomes and expenses incurred by the company. You are required to calculate earnings before tax of the company for the year 2018-19.
| Particulars | Amount ($) |
| Sales during the year | $50,000 |
| COGS | $15,000 |
| Rent Expense | $2,000 |
| Salary to staff | $5,000 |
| Administration cost | $1,000 |
| Depreciation | $1,500 |
| Interest Cost | $500 |
Solution:
| Calculation of Profits Before Tax | |
| Particulars | Amount ($) |
| Revenue | |
| Sales during the year | 50,000 |
| (A) | 50,000 |
| Expenses | |
| COGS | 15,000 |
| Rent Expense | 2,000 |
| Salary Expense | 5,000 |
| Admin Expense | 1,000 |
| Depreciation | 1,500 |
| (B) | 24,500 |
| EBIT (Earnings before Interest & Tax) (C) = (A – B) | 25,500 |
| Interest Cost (D) | 500 |
| EBT (Earnings before tax) (E) = (C-D) | 25,000 |
Example #2
Below is an extract of a company’s income statement for the year ended 2019. You are required to calculate Earnings before tax using the information given below.
| Particulars | Amount ($) |
| EBIT | 50,000 |
| Interest cost | 5,000 |
| Taxes | 2,500 |
| Net Profits | 42,500 |
Solution:
Earnings before Tax is calculated as
Earnings before Tax = EBIT – Interest
- Earnings before Tax = 50,000 – 5,000
- Earnings before Tax = 45,000
Earnings before Tax is calculated as
Earnings before Tax = Net Profits + Tax
- Earnings before Tax = 42,500 + 2,500
- Earnings before Tax = 45,000
Importance of Pretax Income
The importance of pretax income is given below:
- Earnings before tax show the company’s actual profitability, as tax cannot be avoided/controlled by the company.
- Also, earnings before tax make different companies’ financial statements across similar industries comparable as the tax rates can differ among the states.
- It is important to understand the company’s operational profitability, which can be known by calculating profits before tax.
Advantages of Pretax Income
Following are some of the advantages of Pre-tax profits:
- Pre-tax profits are one of the major tools to evaluate the company’s financial performance. Both internal and external management gets the financial data to find how the company is performing.
- Another advantage is that comparing the financial data of various companies at the Pre-tax profit level becomes easier as the tax rates and rules differ across borders.
Disadvantages of Pretax Profits
Following are some of the disadvantages of Pre-tax profits:
- Pre-tax profits do not consider the tax impact on the profits, which sometimes can have a huge impact on the financial results. For example, the government is given certain tax benefits to the industry operating in certain regions, which can help increase the company’s net income.
- It does not provide the actual Income earned by the company as it does not account for the tax for the period.
Conclusion
Pre-tax profits measure a company’s profitability without taking the tax impact. Investors and shareholders often look at this number only to understand the company’s financial performance. However, excluding taxes also helps to compare the financial results across the industry at similar levels.
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