What is NPAT?

What is NPAT?

NPAT stands for net profit after tax. This measures the operating profit of a business after all costs and expenses have been accounted for (including tax). 

NPAT is one of the most important metrics used in measuring business performance. This is because NPAT measures the profitability of a company. Businesses must monitor their profits to evaluate their financial success and viability. But factors such as taxes, debts, and expenses can impact how profits appear.

Measurements such as NPAT provide an easy to understand way of evaluating the profitability of a business over a specific time period. 

How is NPAT calculated?

NPAT is determined by taking the total income of a business and subtracting all costs including applicable taxes. One-off costs, such as those related to an acquisition, are not included in the calculation. This is because these costs are not incurred on a regular basis so they don’t provide an accurate representation of the company’s true profitability.

Tax savings that companies may receive because of existing debt are also excluded from the calculation. 

NPAT will only be positive provided the income and revenue of a business are greater than its expenses. If expenses are greater than income, it means the money a business makes from selling its products or services is not enough to cover the cost of producing those products or services. 

If no profit is made, no tax will be payable and the company may also be able to carry forward the loss to offset profits in future tax years. Many businesses are not profitable in their early years.

Ultimately, however, investors want the businesses they invest in to be profitable, as it is the profits that flow to shareholders through dividends and long-term growth in the share price.

When NPAT is positive, it represents cash that the business can use in a number of 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 business, reducing the total number of shares on issue. 

How a company chooses to use its NPAT will depend 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 choose to retain profits to fund future growth. 

An example of NPAT calculations

If Company A makes $90 in revenue and an additional $10 in income over a year, its total income for the year will be $100. In order to earn that income, let’s assume Company A spent $30 on employee salaries, $10 on rent, and $10 on marketing. 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 tax of $15. Once tax is deducted from the net profit before tax, we get NPAT, which in this case will be $35. 

Why is NPAT an important metric for companies?

NPAT is one of the most important metrics because companies ultimately exist to generate profits. Any time a profit is generated, there will be tax to pay, so NPAT represents the profit available to be shared with the owners of the business (the shareholders). 

NPAT provides an indication of the health of a business and is a key parameter used by shareholders and analysts to evaluate business performance. Because one-off expenses are excluded, NPAT indicates how operationally efficient a business is, with a higher NPAT indicating greater efficiency.

Dividends and share prices are also linked to NPAT. Dividends are paid out of profits, so they should be higher when the NPAT is higher, all else being equal. Growth in profits (which NPAT measures) will usually bolster the share price of a company, 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, with the aim of increasing future NPAT. An increase in NPAT over multiple periods makes investors view the business favourably, which will usually lead to an increase in the share price. 

Decreases in NPAT, on the other hand, can indicate a decline in sales, poorly-managed expenses, excessive debt, or poor execution on management strategy. 

 

The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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