Understanding 'Income Before Tax' on an Income Statement
And How Corporate Income Taxes Come Into Play
Income statements are one of three financial statements that companies use to report their performance over an accounting period. These statements (along with the balance sheet and cash flow statement) are essential reading for investors to understand the companies they're investing in.
One of the most important lines to understand on an income statement is income before taxes. After deducting interest payments, and depending on the business and other expenses, you're left with the profit a company made before paying its income tax bill.
Learn more about why investors should look at a company's income before taxes, also known as pretax earnings.
The Utility of Income Before Taxes
Income before taxes can be a particularly useful metric, especially if you examine it over multiple years by comparing it to other metrics.
Pretax income is calculated by subtracting a company's operating expenses from its revenue. For example, if a company has $10 million in revenue and its operating expenses are $8 million, it has $2 million in income before taxes.
Operating expenses include the cost of goods sold (COGs), depreciation, insurance, and interest.
Looking at income before taxes is informative because income tax laws change from time to time depending on economic, social, and political factors. This causes after-tax income to fluctuate in a way that doesn't always indicate the economic engine a business has running under the hood.
Income before taxes should be more consistent than after-tax income. Look at a firm's long-term income before taxes figure and compare it to total sales, tangible assets, or shareholders' equity. Put it side by side with other companies in the same sector or industry to fully understand its performance. Certain industries tend to outperform other industries by this metric, so making an apples-to-apples comparison is of particular importance for this type of analysis.
Looking at income before taxes also helps with comparing companies because while everyone has the same federal tax rate, state taxes vary significantly.
Pretax Profit Margin
The pretax profit margin is when you compare income before taxes to total sales. It tells you how many cents a company made in profits for each dollar in sales. You find the pretax profit margin by dividing the income before taxes by total sales and multiplying it by 100.
For example, if a firm has $1 million in total sales and pretax income of $200,000, the firm has a pretax profit margin of 20%. That means that for every $1 in product sold, it made 20 cents.
Income Tax Expenses on the Income Statement
The income tax expense is the total amount the company paid in taxes. This figure is frequently broken out by source (federal, state, local, etc.) on the income statement, in the annual report, or Form 10-K filing.
You should be familiar with the tax laws affecting specific companies and/or business transactions. For example, say the business you were analyzing purchased $100 million worth of preferred stock that boasted a dividend yield of 9% at the time of acquisition.
You could rightly assume the company would receive $9 million a year in dividends on that preferred stock. If the company had a tax rate of 35%, you might assume that $3.15 million of those dividends will be paid to Uncle Sam. In truth, corporations get an exemption on 70% of the dividends they receive from preferred stock, an advantage that individual investors don't enjoy. Because of this advantage, only $2.7 million of the $9 million in dividends would be subject to taxation.
Corporate tax rates in the United States have varied significantly over time. In the past, they were often progressive taxes (tax brackets in which tax rates go up as a corporation's taxable income rises), but as of 2020, the corporate tax rate is a flat tax of 21% on all earnings of one dollar or more. Keep in mind that certain businesses risk triggering additional, special taxes, such as those levied on holding companies organized as classic C-corporations.
Once income taxes are deducted from a firm's income before taxes, you're left with net income. This is more frequently used to compare profitability between companies, but looking at income before taxes is also informative and, in some ways, a better measure of fiscal health.