Understanding net profit after tax
Net profit after tax, or NPAT, is the money a company has left over after it accounts for all costs and expenses, including tax.
NPAT is one of the most important metrics used in measuring business performance. It measures a company's profitability after all operating expenses, interest, taxes, and other costs have been deducted from total revenue.
Other profit measures, such as operating or gross profit, may exclude expenses such as interest and taxes. NPAT, however, provides a comprehensive measure of the profitability of a business over a specific period.
How is NPAT calculated?
To calculate NPAT, we start with the company's total revenue and deduct the cost of goods sold, such as materials and labour. This provides the company's gross profit.
From this figure, we can deduct the company's operating expenses, such as rent, utilities, and marketing expenses. This provides the earnings before tax figure.
Finally, we deduct any taxes the business needs to pay on its earnings to get NPAT.
Here's an example: If Company A makes $90 in revenue and an additional $10 in income over a year, its total annual income will be $100. Let's assume Company A spent $30 on employee salaries, $10 on rent, and $10 on marketing to earn that income. This means Company A incurred costs of $50.
Subtracting the costs ($50) from the total income ($100) gives us a net profit before tax of $50. Company A will need to pay tax on this profit at a rate of 30%, so it will owe a tax of $15. Once we deduct tax from the net profit before tax, we get NPAT, which in this case will be $35.
Positives and negatives
NPAT will be positive if a company's revenue exceeds its expenses. When positive, it represents cash that the company can use in several ways. It may be reinvested to grow the business, paid out to shareholders in the form of dividends, or used to repurchase shares in the company, reducing the total number of shares on issue.
When expenses are higher than revenue, the money a company makes from selling its products or services is insufficient to cover the cost of producing those products or services.
No tax will be payable if a company does not make a profit, and it can carry forward the loss to offset profits in future tax years. This helps many businesses that are not profitable in their early years.
Ultimately, however, investors want the companies they invest in to be profitable, as the profits flow to shareholders through dividends and long-term share price growth.
How a company uses its NPAT depends on many factors, including its future plans and outlook, shareholder expectations, and market conditions.
Large, well-established companies may be more likely to pay out profits to shareholders as dividends. Smaller companies and those with significant growth opportunities may retain profits to fund future growth.
Why is NPAT an essential metric for companies?
NPAT is one of the most important metrics because companies ultimately work to generate profits. Any time a company generates profit, there will be tax to pay, so NPAT represents the profit available to be shared with the business owners (shareholders).
NPAT typically includes one-off or non-recurring costs that are not part of usual business operations. Examples are costs from legal settlements, restructuring charges, and asset write-downs.
However, it's important to note that one-off expenses can distort the profitability picture. For instance, a large one-time expense might significantly reduce NPAT for a particular period, but this may not indicate the company's ongoing financial health or profitability.
For a clearer understanding of a company's underlying performance, analysts often look at both NPAT and adjusted profit measures. Adjusted profits exclude one-off items to provide a better sense of the company's recurring profitability. This helps investors make more accurate comparisons over time or against companies that might not have incurred similar one-off expenses.
Where do dividends come in?
Dividends and share prices are also linked to NPAT. Companies pay dividends out of profits, so they should be higher when NPAT is higher, all else being equal. Growth in profits (which NPAT measures) will usually bolster a company's share price and vice versa.
The NPAT of a company will determine whether it can reward its shareholders through dividends or share buybacks. Of course, a company can also choose to reinvest profits into the business to fuel growth and thereby increase future NPAT. An increase in NPAT over multiple periods makes investors view the company favourably, which will usually lead to a rise in the share price.
Conversely, a decreased NPAT can indicate a decline in sales, poorly managed expenses, excessive debt, or poor execution of management strategies.
Frequently Asked Questions
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The NPAT financial statement refers to the section of a company's financial reporting that discloses its net profit after tax. We determine NPAT by subtracting all operating expenses, interest, and taxes from a company's total revenue. NPAT indicates a company's profitability after it meets all financial obligations, including tax liabilities. NPAT is typically found in a company's income statement (also known as a profit and loss statement), which provides a detailed summary of a company's revenues, expenses, gains, and losses, ultimately revealing the net profit or loss for that period.
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Both are measures of financial performance, but they focus on different aspects of performance. A company's EBITDA excludes expenses like interest, taxes, depreciation, and amortisation from its earnings. EBITDA focuses on profitability from a company's core operations, omitting the effects of financial and accounting decisions. It measures earnings without considering financing costs (interest), accounting practices (depreciation and amortisation), and tax. EBITDA can help investors assess operational efficiency and compare companies with different capital structures or operating under different tax regimes.
NPAT, on the other hand, includes all expenses and taxes, so it is a better indicator of overall profitability and financial health. Since NPAT comprises the full impact of a company's tax strategy and interest expenses, it's a crucial metric for investors making long-term investment decisions. A consistently high NPAT suggests a strong financial position and could indicate a company's ability to sustain dividends or invest in future growth.
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The terms 'net profit' and 'NPAT' are often used interchangeably but can have slightly different connotations depending on the context. Generally, net profit refers to a company's profit after deducting all costs and expenses from its total revenue. NPAT, on the other hand, emphasises the inclusion of tax expenses in its calculation. It's the profit after accounting for all operating costs, interest, and taxes. NPAT reveals how much profit is left after fulfilling all financial obligations, including tax liabilities, while net profit may not take account of the impact of taxes on profits.