Definition of Profit Before Tax
Profit before tax (PBT) defines and calculates the profits earned during an accounting period on an income statement. It considers revenue, operating costs (including the cost of goods sold, general selling, administrative expenses, amortization, and depreciation), and all other non-operating income and expenses (such as interest) before accounting for income tax expenses for that period.
Explanation
Profit Before Tax (PBT) is a crucial financial metric that consolidates and presents a company’s overall profitability by encompassing various revenue and cost components. It contains operating and non-operating profits, incorporating income from regular business activities, seasonal operations, and continuous operations. PBT is particularly significant because tax expenses tend to fluctuate, and by excluding them, investors can better understand year-to-year changes in a company’s earnings. Found as a separate entry in the profit and loss account, PBT is usually positioned as the third-to-last line. The line preceding it represents tax expenses, while the final line indicates the net profit. Since tax rates vary based on the company’s location, relying solely on profit after tax may not adequately reflect its true earning capacity. PBT reflects a company’s profitability and is often expressed as a percentage of revenues, revealing how much profit is generated per dollar of revenue earned.
Formula for Profit Before Tax
The formula to calculate profit before tax is as below:
OR
- Revenue from operations: Income earned from normal business activities of the company in the normal course of time.
- Revenue from non-operating activities: Income earned from sources not part of core business activities -like sale of assets, interest income, dividend income, etc.
- Cost of goods sold: The cost incurred directly in making the product, like material, labor, etc.
- Operating expenses: Expenses that are incurred to run and maintain the business in a normal course. These expenses cannot be avoided.
- Non-Operating expenses: These are the expenses that do not form part of the normal business-like loss on the sale of an asset, interest expense, commission, etc.
How to Calculate Profit Before Tax?
PBT is the net inflow considering all accrued income irrespective of its source, whether operating or non-operating, like sales, revenue from services, commissions, interest income, dividend income from extraordinary transactions, etc. Also, after deducting all the expenses except the corporate income tax.
To calculate the profit before tax, these steps must be followed.
- Step 1: Gathering of all financial data about income earned by the company – Under this step, the information regarding the income of the company must be gathered as the money received from the normal course of business, money received from other sources like rent received, discounts received, interest received, dividend received, income from the sale of an asset, etc. these all incomes must be added together to form the total revenue of the business. Please note that cash collected and all such revenue accrued over the accounting period will be considered.
- Step 2: Deduct the cost of goods sold – All the costs must be determined and deducted from the total revenues. Cost of goods sold included direct material, labor overheads, etc.
- Step 3: Derivation of operating profit – This step involves the reduction of operating expenses that are incurred in the normal running of business-like depreciation, amortization, rent, utility payment, etc., from total revenue made.
- Step 4: Deduct non-operating expenses – Under this step, all the expenses which are not part of the normal business activity, like interest, any loss due occurred due to fire, theft, etc., must be deducted from the figure obtained in step 3.
- Step 5: The figure obtained above is the profit before tax.
Example of Profit Before Tax
The following are the details of Amazon Inc.’s sales revenue of $1,00,000, cost of goods sold of $40,000, selling and general expenses of $10,000, depreciation and amortization$2,000 other expenses of $15,000, and an interest charge of $5,000. Non-recurring income $20,000. Income tax expenses $5,400.
With Amazon’s profit and loss statement, you can get an accurate understanding of the business performance and profitability by tracking expenses against sales.
Determine profit before tax for the period.
Solution:
Profit before tax can be derived as follows: –
PBT = Revenue from Operating Activities + Revenue from Non-Operating Activities – Cost of Goods Sold – Operating Expenses – Non-Operating Expenses
| Particulars | Amount ($) |
| Sales Revenue | 1,00,000 |
| Cost of Goods Sold | 40,000 |
| Gross Profit | 60,000 |
| Less:- Operating Expenses | |
| Selling and General Expenses | 10,000 |
| Depreciation and Amortization | 2,000 |
| Other Expenses | 15,000 |
| Total Operating Expenses | 27,000 |
| Operating Profit | 33,000 |
| Add: | |
| Non-Recurring Income | 20,000 |
| Earning Before Interest and Tax | 53,000 |
| Less: Non-Operating Expenses | |
| Interest Expenses | 5,000 |
| Profit Before Tax | 48,000 |
Therefore, the profit before tax of Amazon Inc is $48,000. Income tax expenses are not considered for PBT calculation; therefore, $5,400 expenses are ignored.
Importance of Profit Before Tax
It is one of the most important indicators of a company’s performance as it takes notes of all the expenses incurred by the company. It provides external and internal stakeholders information regarding performance during an accounting period. As it excludes tax which could make data non-comparable in a different state, the country might have a different taxation structure. Therefore, PBT becomes a better source of performance indicators. Profit before tax depicts actual accrued profits, whether realized in cash or not. Various stakeholders widely use this term to conduct financial statement analysis, trend analysis, determine a company’s growth performance, etc.
Advantages
- It helps companies analyze businesses with the same characteristics, businesses, and scale on a comparative basis.
- Profit after tax can mislead an organization’s comparative performance due to its subjectivity to different tax systems, and therefore PBT emerges as a better analysis medium.
- It is more inclined towards performance measurement rather than profitability calculation.
Disadvantages
- PBT is not a restorative measure for comparison purposes if the business’s operations are not similar in nature and scale.
- It does not consider tax, which may mislead the statements as the company’s profits may be eligible for tax benefits.
- Also, it does not reflect on cash profits generated during the accounting period. Sometimes, the organization may be more interested in knowing its cash position than profitability.
Conclusion
Profit before tax is an important financial terminology. It considers every transaction accounted for during an accounting period except a tax for measuring business performance. PBT analysis always considers different expense recognition principles in different businesses. For an investor, profit before taxes is an important measure of comparing business performance under different economic conditions and tax rates. Although other financial measures are more commonly used, like PAT, EBIT, and operating profit, the interested stakeholder may use PBT for their calculations depending on the requirement.
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