What Is Pre-Tax Margin?
When researching the fundamentals of a business opportunity, investors are usually most concerned with profitability, both in the short and long term. For investments in companies, investors usually want to look at their profit margins and their ability to deliver growth. Understanding pre-tax margin, an important metric for assessing profitability, is critical to investment research.
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Components of Pre-Tax Margin
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Pre-tax margin is a financial ratio that is figured using three metrics from the income statement: net income, tax expenses and net revenues. Pre-tax margin or pre-tax profit is the net income -- excluding tax expenses -- divided by revenues. In this way, pre-tax margin is essentially the percentage of total revenue that is left over after all expenses are deducted, but before the business pays its taxes.
Net Income and Revenues
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The first component of pre-tax margin is net income. Net income is merely the amount that remains of a business's gross income, or total revenues, after all the company's expenses are deducted. This figure is also called "the bottom line" because it is reported on the bottom line of an income statement. Total revenues are the amount of money that a businesses brings in from its customers, usually from sales. In some cases, income from operations is used to compute the pre-tax margin to give a better picture of the company's core business profitability. In this case, the ratio is called the pre-tax operating margin.
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Tax Expense
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An inevitable fact of doing business is the need to pay taxes. The problem with including tax expense in examinations of the profit margin is that this expense "often swings for reasons that have nothing to do with the company's operations, such as tax-loss carry-forwards and various credits," according to Matt Krantz of USA Today. This can severely distort an investor's assessment of the company's profitability; special or temporary tax credits can result in an unreasonably positive outlook, while temporary tax losses might cause an investor to unfairly discount an otherwise good opportunity.
Using Pre-Tax Margin
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To eliminate the potential distortions of taxes, investors factor out tax expenses with the pre-tax margin and possibly get a better idea of the company's ability to deliver income from its core business. In other words, "it can help to determine the overall operating efficiency of the firm," according to Becca Lipman of the Motley Fool. Similarly, businesses that rely too heavily on tax credits or write-offs to secure a profit margin might not be as good an opportunity, as the business could easily collapse if tax benefits ceased to exist.
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