Pretax Profit Margin: Definition, Uses, Calculation, Example

What Is a Pretax Profit Margin?

The pretax profit margin is a financial accounting tool used to measure the operating efficiency of a company. It is a ratio of the percentage of revenues that are turned into profits or how many cents a business pockets from each dollar of sale, before deducting taxes. The pretax profit margin is widely used to compare the profitability of companies within the same industry.

Understanding Pretax Profit Margin

Most companies aim to generate as much profit as possible. That's usually what the people in charge are tasked with doing and what investors funding its activities demand.

One of the most common and useful measures to gauge corporate profitability is to look at profit margins. Consistently high pretax profit margins are a sign of a healthy company with an efficient business model and pricing power. Low pretax profit margins suggest the opposite.

To boost profitability, management teams must strike a balance between increasing sales and reducing costs. Pretax profit margins provide an indicator of how successful companies are at achieving this goal. As a result, pretax profit margins are closely watched by analysts and investors and frequently referred to in financial statements.

The pretax profit margin offers investors one of the best ways to compare competing companies, as well as those with significant differences in size and scale in the same industry. Generally, businesses that regularly deliver higher pretax profit margins than their peer group can be thought of as better run.

How To Calculate Pretax Profit Margin

Pretax profit margin only requires two pieces of information from the income statement: revenues and earnings before taxes (EBT).

The percentage ratio is calculated by dividing EBT—which sometimes may be called pre-tax income, profit before tax, or income before income taxes, and appears just above the net income line item—by sales and then multiplying the resulting number by 100.

Pretax Margin 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 made by 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, resulting in a ratio of 8%.

Pretax Profit Margin vs. Profit Margin

Often, profit margins after taxes gain more prominence among analysts and investors. However, it can be argued that tax payments offer little insight into the efficiency of companies and should, therefore, be stripped out of the equation.

Tax expenditures can make profitability comparisons between companies misleading. Tax rates vary from state to state, are generally out of management’s control, and aren’t necessarily a fair reflection of how a business is performing. One alternative comparison ratio is the Berry ratio, which compares gross profit to operating expense.

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 the pretax profit margin.

Limitations of the Pretax Profit Margin

Though very insightful, pretax profit margins, like other financial ratios, have limitations. For one, they cannot be used effectively to compare companies from other sectors as each industry generally has different operating expenses and sales patterns.

Certain sectors are more profitable than others. Legal services is an example of a high-margin profession. Overheads are low—there’s little need for big investment costs, other than salaries—and demand is fairly constant. In contrast, other sectors, such as airlines, have to deal with stiff competition, fluctuating prices for key materials such as fuel, hefty maintenance expenses, and countless other costs. For this same reason, investors should also be cautious about using pretax profit margins when comparing diversified companies serving several industries.

When used correctly, pretax profit margins can provide a useful gauge of business efficiency. However, to get a complete grasp of a company’s health, investors are always advised to use the pretax profit margin in tandem with other metrics. The more you know about a company, the better able you are to establish whether it is worth investing in.

The Bottom Line

The pretax profit margin represents the portion of a company’s sales revenue that it gets to keep as a profit after subtracting all of its costs other than taxes. If a company reports a 25% pretax profit margin, it means that it netted $0.25 from each dollar of sales generated before paying taxes.

Profit is the metric that companies and investors often pay the most attention to, and the pretax profit margin is one of the best ways of gauging it. Taking tax out of the equation makes sense because these payments vary across jurisdictions, fluctuate, and generally offer little insight into the efficiency of companies.