Pretax Profit Margin

What is 'Pretax Profit Margin'

Pretax profit margin is a company's earnings before tax as a percentage of total sales or revenues. The higher the pretax profit margin, the more profitable the company. The trend of the pretax profit margin is as important as the figure itself, since it provides an indication of which way the company's profitability is headed.

BREAKING DOWN 'Pretax Profit Margin'

Profit is the main goal of for-profit organizations. The goal is to make a profit through growth and to grow every year. As a result, one of the most important roles of the financial and investment analyst is to track and forecast profitability. Financial analysts working inside a company must analyze profitability to learn what the company can do to improve sales. In addition to sales growth, the company can grow profits through cost savings. Indeed, it is the goal of every company to grow sales while reducing expenses. Companies that do this well experience an increase in pretax profit margin.

Taxes are not a function of operations. As such, they are not included in operating expenses. Some analysts view taxes as a necessary cost that should not be considered when analyzing the performance of the company. That is, a company can manipulate the amount it pays in taxes, but it is not the goal of operations. Additionally, at times, tax expense can be larger than it has been in previous years due a tax penalty. Likewise, at times, tax expense may be much lower than it has been in previous years due a tax credit. In this case, analysts may be able to decrease earnings volatility by calculating pretax margin.

Pretax Margin Example

Pretax profit margin is calculated by deducting all expenses from sales except for taxes, and then dividing by sales. It can also be calculated by adding taxes back to net income or by dividing net income by '1 minus the effective tax-rate,' and then dividing by sales.

For example, suppose that company A has gross profit of $100,000, operating expenses of $50,000 and interest expense of $10,000, with sales of $500,000. Earnings before taxes are calculated by subtracting operating expense and interest expense from gross profit. The calculation is $100,000 minus $50,000 minus $10,000, or $40,000. So pretax earnings are $40,000 and total sales are $500,000 for the given fiscal year. Pretax margin is calculated by dividing pretax earnings by sales, which is $40,000 divided by $500,000, or 8%. The pretax profit margin enables profitability to be compared across companies with significant differences in size and scale. Company B, which has $750,000 in sales and $50,000 in pretax earnings, may have higher profitability than company A in dollar terms, but has a lower pretax profit margin of 6%.