Whether you're a one-person shop or a multimillion dollar corporation, you report your pretax income on the income statement for your business. Also known as earnings before tax, or EBT, you'll find pretax income almost at the bottom of the statement. It's the final item you calculate before figuring net earnings for the quarter, month or year. There are several methods of pretax income calculation.
TL;DR (Too Long; Didn't Read)
The simplest pretax income formula is to take your sales revenue for the period, subtract the cost of goods sold, and then deduct all your expenses except taxes. This gives you the EBT.
The Income Statement
The income statement is one of the basic business financial statements along with the balance sheet and cash-flow statement. Unlike the cash-flow statement, the income statement shows transactions where no cash has traded hands yet.
For example, suppose you've completed a $2,000 job for a client but haven't received payment. You report the $2,000 on your income statement but not your cash-flow statement. You reach your pretax income on the income statement after working through several line items:
- Cost of sales. This is calculated as beginning inventory plus extra purchases and less ending inventory.
- Gross profit. This is your revenue less the cost of sales.
- Expenses. Depending on your company, these line items may include research and development, administration, salaries, rent, overhead, amortization and interest. These items are sometimes called SG&A, or selling, general and administrative expenses.
- Earnings before tax. Subtract expenses from gross profit, and you get EBT.
- Net income. When you subtract your tax bill from the pretax income on the income statement, you get your net income for the period.
Sample Pretax Income Calculation
Suppose your business specializes in upscale leather goods, from shoes to luggage to purses. Sales revenue for the past quarter was $180,000, and your cost of goods sold was $80,000. SG&A was $60,000. You paid $10,000 in interest on loans you've taken out.
Subtracting cost of goods sold from sales revenue gives you a gross profit of $100,000. Subtracting SG&A gives you $40,000 in EBIT, or earnings before interest and taxes. Subtracting $10,000 in interest gives you an EBT of $30,000.
The income statement may be much more complicated. If your business has income or losses from loans or investments, for example, you report that nonoperating income separately from sales income. Losses from fire or theft get their own line on the income statement too.
Alternative Pretax Income Formula
If you know your EBIT, you can calculate EBT by subtracting interest from the earnings before interest and taxes. A third pretax income calculation is possible if you know your net income and your tax bill for the accounting period. You can add them together to get pretax income.
Importance of Pretax Income
Subtracting taxes from EBT tells you how much income you have left after all your expenses, including taxes. That's an important figure, but the pretax income calculation also gives you valuable information.
Tax expenses often fluctuate year to year depending on government tax policies and the countries, states or cities in which you're operating. Looking at your earnings before tax and seeing how they compare from year to year can be a better indicator of your company's performance. You can also use EBT to compare your company with other businesses that may have different tax issues.
One way to compare companies regardless of size is to use a profitability ratio. Divide pretax income by total sales – the higher the ratio, the greater the profitability. If, say, EBT is $40,000 and total sales income is $100,000, the ratio is 40 percent.
- Because businesses and individuals use many techniques to minimize their tax liability, pretax income is usually a more accurate way to measure profit. The pretax income can be used to apply for loans or invite investors into a business.
Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs. His website is frasersherman.com