Profitability Indicator Ratios: Effective Tax Rate
  1. Profitability Indicator Ratios: Introduction
  2. Profitability Indicator Ratios: Profit Margin Analysis
  3. Profitability Indicator Ratios: Effective Tax Rate
  4. Profitability Indicator Ratios: Return On Assets
  5. Profitability Indicator Ratios: Return On Equity
  6. Profitability Indicator Ratios: Return On Capital Employed

Profitability Indicator Ratios: Effective Tax Rate

By Richard Loth (Contact | Biography)

This ratio is a measurement of a company's tax rate, which is calculated by comparing its income tax expense to its pretax income. This amount will often differ from the company's stated jurisdictional rate due to many accounting factors, including foreign exchange provisions. This effective tax rate gives a good understanding of the tax rate the company faces.

Formula:

Components:


As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had a provision for income taxes in its income statement of $307.30 (income statement), and pretax income of $1,040.70 (income statement). By dividing, the equation gives us an effective tax rate of 29.5% for FY 2005.

Variations:
None

Commentary:
The variances in this percentage can have a material effect on the net-income figure.

Peer company comparisons of net profit margins can be problematic as a result of the impact of the effective tax rate on net profit margins. The same can be said of year-over-year comparisons for the same company. This circumstance is one of the reasons some financial analysts prefer to use the operating or pretax profit figures instead of the net profit number for profitability ratio calculation purposes.

One could argue that any event that improves a company's net profit margin is a good one. However, from a quality of earnings perspective, tax management maneuverings (while certainly legitimate) are less desirable than straight-forward positive operational results.

For example, Zimmer Holdings' effective tax rates have been erratic over the three years reported in their 2005 income statement. From 33.6% in 2003, down to 25.9% in 2004 and back up to 29.5% in 2005. Obviously, this tax provision volatility makes an objective judgment of its true, or operational, net profit performance difficult to determine.

Tax management techniques to lessen the tax burden are practiced, to one degree or another, by many companies. Nevertheless, a relatively stable effective tax rate percentage, and resulting net profit margin, would seem to indicate that the company's operational managers are more responsible for a company's profitability than the company's tax accountants.

Profitability Indicator Ratios: Return On Assets

  1. Profitability Indicator Ratios: Introduction
  2. Profitability Indicator Ratios: Profit Margin Analysis
  3. Profitability Indicator Ratios: Effective Tax Rate
  4. Profitability Indicator Ratios: Return On Assets
  5. Profitability Indicator Ratios: Return On Equity
  6. Profitability Indicator Ratios: Return On Capital Employed
RELATED TERMS
  1. Effective Tax Rate

    The average rate at which an individual or corporation is taxed. ...
  2. Net Of Tax

    An accounting figure that has been adjusted for the effects of ...
  3. Future Income Tax

    Income tax that is deferred because of discrepancies between ...
  4. Marginal Tax Rate

    The amount of tax paid on an additional dollar of income. The ...
  5. Tax Rate

    The percentage at which an individual or corporation is taxed. ...
  6. Net Income - NI

    1. A company's total earnings (or profit). Net income is calculated ...
RELATED FAQS
  1. How are effective tax rates calculated from income statements?

    Learn how to read an income statement and how to find the information necessary to calculate a company's effective income ... Read Answer >>
  2. How does the effective tax rate for an individual differ from that of a corporation?

    Read about the effective tax rate for individuals when compared with the effective tax rate for corporations, including how ... Read Answer >>
  3. How does the marginal tax rate system work?

    The marginal tax rate is the rate of tax that income earners incur on each additional dollar of income. As the marginal tax ... Read Answer >>
  4. What is the income breakdown for the effective tax rate?

    Read about the effective tax rate, how the marginal income tax brackets affect it and how the denominator in its formula ... Read Answer >>
  5. Do tax liabilities appear in the financial statements?

    Find out how taxes are shown on the balance sheet, the income statement and the cash flow statement, and why taxes are an ... Read Answer >>
  6. What's the difference between the marginal tax rate system and a flat tax?

    Find out about the difference between marginal tax rates and flat taxes. Gain insights on both systems and the arguments ... Read Answer >>

You May Also Like

Hot Definitions
  1. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  2. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  3. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  4. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  5. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  6. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
Trading Center