Profit Before Tax – Meaning, Formula, Pros and Cons

Profit Before Tax (PBT) is a commonly used term in finance. The measure gives the value of profits a company has earned before paying any corporate taxes to the Government. 

The metric gives the investors an overview of a company’s gross profits before meeting Government obligations. In this sense, it depicts the true profit-earning potential of the company. Read on to learn what profit before tax is and how to calculate PBT.

What is Profit Before Tax?

The profit before tax is a popular metric that measures a company’s profitability before it fulfils its obligations of paying taxes to the government. The profit before tax metric helps the investors understand how profitable the company is and how well it performs. 

Profit before tax is also known as earnings before tax. You can extract the value of profit before tax from the company’s income statement. You get the value of PBT when you subtract the interest amount from the company’s operating profit or EBIT (Earnings Before Interest and Tax).

• The profit before tax is an important financial measure that helps you understand the company’s profitability.
• PBT can be calculated by subtracting the interest from the company’s operating income or EBIT.
• You can find the profit before tax on the company’s income statement.
• The profit before tax is a great measure to compare two or more companies in the same industry.

How to calculate profit before tax?

If you are wondering how to calculate PBT, let’s take a step-by-step approach to understand the calculation. 

• You need to factor in all the company’s earnings and bring them together to calculate profit before tax. These earnings come from various sources like regular business operations, rental income, etc.
• Once you have ascertained the company’s total income, calculate all the expenses that the company is bearing. The most common expenses include rent, debt, COGS (Cost of Goods Sold), etc.
• Now, subtract the deductible expenses from the sum of the total of all the revenue or the company’s income to get the profit before tax.

Formula to calculate profit before tax

Suppose you want to use PBT to compare the profitability of two or more companies or to analyse a company’s profitability; in that case, you must know the profit before tax formula. The PBT formula is quite straightforward.

The profit before tax formula is: 

Profit before tax = Revenue of the company – Expenses of the company

Or

Profit before tax = Operating income of the company – Interest payments

Significance of profit before tax

Now that you know how to calculate PBT, you must understand the metric’s significance. 

PBT is one of the most important measures of understanding the company’s profitability. It quantifies the company’s profitability and helps the external and internal stakeholders understand its financial performance and raw profitability. 

As profit before tax does not include the tax payments, it gives you the accurate value of the company’s earnings (post-bearing all the operating expenses). Interest expenses are a major expense for the company, and the PBT gives you an overview of its residual income once it bears all its interest expenses. 

The profit before tax is also the value that decides the amount of tax the company must pay the Government. Also, the company and investors use profit before tax to calculate the PBT margin of the company. Naturally, the PBT margin of any company is higher than the net income margin as the taxes have not been deducted yet.

Another important aspect of profit before tax is that it excludes a variable that hugely impacts the company’s profitability. For instance, some companies pay a corporate tax of 25% based on their turnover. However, some other companies might enjoy the benefits of tax breaks, exemptions, etc. Hence, the value of profits after deducting taxes will not give a true picture of how well the company is performing.

Disadvantages of PBT measure

While the PBT formula is widely used to understand the company’s performance and profitability, the measure also has some disadvantages. Some of these disadvantages include:

• While it helps you understand the company’s profitability, you do not get any information on its bottom line. The company’s bottom line gives you the amount earned at the end of the financial year. 
• Different companies have different kinds of operations, and they also have different scales of operations. Hence, you cannot use profit before tax to compare the performance of different businesses.
• Using PBT to assess the net income of businesses operating in the dynamic business environment is challenging. 

PBT vs EBIT

The terms profit before taxes and earnings before interest and taxes are often used interchangeably. However, both measures are quite different from each other. While both these metrics give an overview of the company’s profitability, they take a different perspective to evaluate performance.

The element that makes PBT different from EBIT is the interest expense that the company bears. The PBT considers the interest expenses while calculating the profitability of the company. At the same time, the EBIT gives you the company’s gross profit without deducting interest.

The EBIT is calculated by subtracting the cost of goods sold and the operating expenses from the company’s total revenue. However, the PBT is calculated by subtracting the COGS, operating expenses, and interest expenses from the revenue. Hence, the value of profit differs in both cases. 

Let’s take an example to understand this better. 

A company earns total revenue of Rs. 2,50,00,000. The cost of goods sold is valued at Rs. 50,00,000, and the company bears an operating expense of Rs. 20,00,000. Additionally, the company will have to bear an interest expense of Rs. 1,00,000. Here, the EBIT will be equal to Rs.2,50,00,000 – (Rs.20,00,000 + Rs. 50,00,000) = Rs. 1,80,00,000.

However, to calculate the PBT, you must subtract the interest expense. Therefore, the PBT will equal Rs. 1,80,00,000 – Rs. 1,00,000 = Rs. 1,79,00,000. The company makes a profit of Rs. 1,79,00,000 before paying corporate taxes.

Conclusion

Now that you understand the PBT meaning, you can use it to calculate the company’s profits before paying taxes. The investors actively use the metric to understand the company’s operating performance. The measure aims to reduce the impact of taxes on the company’s profitability. 

FAQs