Pretax IncomeExplained & Defined

Written By:
Adiste Mae

Reviewed By:
FundsNet Staff

What is Pretax Income?

Pretax income is the income a company earns after the deduction of the operating expenses, depreciation expenses, interest expenses, and before taxes are deducted.

Other names for pretax income are income before tax or pretax earnings.

The Formula for Pretax Income

The formula to compute pretax income is shown below:

Pretax Income = Gross Revenue – Operating, Depreciation, and Interest Expenses + Interest Income

Where:

• Gross Revenue – gross income generated by the company (operating/non-operating revenue)
• Operating Expenses – these are expenses incurred by the company in running the business, which includes depreciation, interest, and amortization expense.
• Interest Income – income generated from loan agreements in which the company acts as a creditor.

Illustrative Example

BuyMore Inc.’s accounting transactions are as follows:

• Gross Revenue: $7,500,000
• COGS: $390,000
• Wages and Salaries: $67,000
• Repairs and Maintenance: $15,000
• General & Administrative Expenses: $289,000
• Interest Expenses: $78,000
• Depreciation and Amortization: $150,000

To compute the pretax income of BuyMore Inc.’s company:

Pretax Income = $7,500,000 – ($390,000 + $67,000 + $15,000 + $289,000 + $150,000 + $78,000) + 0

Pretax Income = $6,511,000

Significance of Pretax Income

Gives information about the company’s financial position.

Users of the information must know the difference between the pretax and after-tax earnings since they provide significant insight into the financial performance of the company before and after the tax amount is considered.

Enables easy, impartial comparisons between and within companies.

Pretax earnings provide an excellent basis for intra-company or inter-company comparison.

Not only does it provide the relevant financial performance of the company, but it also prevents management from making decisions based on after-tax earnings that could significantly skew data.

The after-tax earnings may change from time to time due to updates in tax rulings and changes in tax rates that may result from unprecedented effects on a company’s financial health.

Aids in monitoring a company’s financial health over time.

The pretax income is the most common evaluation and monitoring tool for a company’s financial performance.

When taxes are considered, the consistency of financial information provided by the pretax earnings is not achieved.

Tax rulings and tax rates change from time to time and this can affect the after-tax earnings information.

Acts as a measure of profitability.

The company may relatively assess its profitability ratio based on the pretax earnings.

It can determine the areas that require improvement through pretax earnings monitoring.

A higher profitability ratio indicates relatively higher pretax earnings.

Following the example above, the profitability ratio of Big Mike Inc. is 87% ($6,511,000/$7,500,000), computed by dividing the pretax earnings by the total sales.

Income Statement Presentation

The pretax earnings are presented on the income statement before the net profit.

It is shown on the income statement as Profit Before Taxes or Earnings Before Taxes.

Pretax Income vs. EBIT

EBIT or Earnings Before Interest and Taxes refers to the company’s net income after interest expenses and taxes are deducted.

While EBT or Earnings Before Taxes is the company’s income after operating, depreciation, interest expenses, and interest income are accounted for.

The key difference between the Earnings Before Interest and Taxes and Earnings Before Taxes is the accounting treatment for interest expenses.

The interest expenses are not recognized in the EBIT computation, while EBT computation requires deducting interest expenses.

The interest income is also added, if applicable, to arrive at the operating income of the company.