What is a 'Pretax Profit Margin'

The pretax profit margin is the ratio of a company's pre-tax earnings to its total sales. The higher the pretax profit margin, the more profitable the company. The trend of the pretax profit margin is as significant as the figure itself. It indicates the direction of the company's profitability.

BREAKING DOWN 'Pretax Profit Margin'

A for-profit organization seeks to make a profit through growth and to sustain or compound that growth annually. As a result, one of the most critical roles of the financial and investment analyst is to monitor 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 build sales while reducing expenses. Companies that do this well will experience an increase in its pretax profit margin.

The exclusion of business taxes from operating expenses is debatable. 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. At times, the tax expense can be more substantial in a current year than in previous years due to tax penalties and new legislation imposing higher tax rates. Alternatively, the present tax expense may be much lower than it had been in earlier years due to tax credits, deductions, and tax breaks. In this case, analysts may be able to decrease earnings volatility by calculating pretax margin.

Pretax Margin Example

The 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, company EZ Supply has an annual gross profit of $100,000. It has operating expenses of $50,000, interest expenses of $10,000, and sales totaling $500,000. The calculation of earnings before taxes is from subtracting the operating and interest costs from the gross profit ($100,000 - $60,000). EZ Supply has pretax earnings of $40,000, and total sales of $500,000 for the given fiscal year (FY). The pretax profit margin is calculated by dividing pretax earnings by sales, which is 8%. 

The pretax profit margin allows profitability to be compared across companies with significant differences in size and scale and among competing companies in the same industry. 

Company Better Butter, which has $750,000 in sales and $50,000 in pretax earnings, has higher profitability than EZ Supply regarding dollars, but it has a lower pretax profit margin, 6.7%.

It's no surprise that the most profitable industry based on pretax profit margins is the service industry.  Accounting, bookkeeping, legal services, and real estate services are among the highest within the service industry.  Service industries capitalize on human capital rather than tangible goods.  Product manufacturing and distribution costs account for much of the expenses that contribute to lower pretax profit margins in the goods industry.

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