Your Money: What profit before and after tax tells about a firm

Total revenue is the sum of operating revenue and other income and is Rs 3,000 crore for HL.

Pre-tax return on sales and post-tax return on sales of companies are two significant profit margins which need to be analysed before buying stocks of the companies. Let us briefly understand the meaning of these two margins along with their application in the investment decision making context.

Let us assume that the operating revenue of Himanshu Ltd (HL) in its recent financial year is Rs 2,500 crore, its other income is Rs 500 crore, raw material consumed is Rs 800 crore, purchase of stock in trade is Rs 100 crore, change in inventory of FG and WIP is Rs 100 crore, depreciation and amortisation is Rs 200 crore, employee benefit expenses is Rs 500 crore, finance costs is Rs 100 crore and other expenses is rs 200 crore. Tax expenses after adjusting for deferred tax is Rs 300 crore.

Pre-tax return on sales
It is otherwise known as Profit Before Tax (PBT). It is computed by dividing the Earnings Before Tax (EBT) amount by the total revenue of a firm. Operating revenue refers to the portion of total revenue that is generated by a firm from its core operating activities (it is Rs 2,500 crore for HL) while other income refers to the revenue generated by a firm from its non-operating activities such as revenue from investments in stocks and bonds of other firms and from the sale proceeds of investments (it is Rs 500 crore for HL). Total revenue is the sum of operating revenue and other income and is Rs 3,000 crore for HL.

Pre-tax return on sales is the excess of total revenue over the operating and non-operating expenses (finance costs) excluding tax expenses of a firm in a specific accounting period. Hence, total pre-tax expenses for HL is `2,000 crore (sum of raw material consumed, purchase of stock in trade, change in inventory of FG and WIP, D&A, employee benefit expenses, finance costs and other expenses).

PBT for HL is Rs 1,000 crore, i.e., Rs 3,000 crore less Rs 2,000 crore. Therefore, pre-tax ROS is 33.33% (i.e 1000/3000 *100). This indicates HL is earning EBT of Rs 33.33 for every Rs 100 of its total revenue. PBT margin helps us in comparing two firms with differences in their tax expenses.

Post-tax return on sales
It is otherwise known as Profit After Tax Margin (PATM) or Earnings After Tax Margin (EATM) or Net Income Margin. It is computed by dividing net income (or PAT) by total revenue of a firm. EAT can be computed by subtracting total tax expenses from the PBT figure. For HL it is Rs 700 crore i.e., PBT of Rs 1,000 crore less tax expenses of Rs 300 crore. After-tax return on sales for HL is 23.33 % (i.e 700/3000 *100). This reflects that HL is earning Rs 23.33 as net profit for every Rs 100 of its total revenue.

PBT and PAT margins are to be computed for every firm. Both PBT & PAT are the line items of interest for shareholders of a firm and hence, an understanding of their meaning and application is a pre-requisite in assessing the attractiveness of the stocks for equity investors.

The writer is associate professor of Finance at XLRI – Xavier School of Management, Jamshedpur