Understanding net profit after tax
Net profit after tax, or NPAT, 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 to measure 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.
How to calculate NPAT
Analysts determine net profit after tax by taking the total income of a business and subtracting all costs, including applicable taxes.
The calculation does not include one-off costs, such as those related to an acquisition. This is because a company does not incur these costs regularly, so they don't accurately represent its true profitability. The measure also excludes tax savings that companies may receive because of existing debt.
NPAT will be positive only if a company's income and revenue are higher than its expenses. Higher expenses than income means the money a company makes from selling its products or services is insufficient to cover the cost of producing those products or services.
If it does not make a profit, 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 companies they invest in to be profitable, as the profits flow to shareholders through dividends and long-term share price growth.
When NPAT is positive, it represents the cash that the company can use in several ways. The company may reinvest it to grow the business, pay to shareholders in the form of dividends, or use to repurchase shares in the company, reducing the total number of shares on issue.
How a company uses its NPAT depends on many factors. These include 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 annual income will be $100. 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 a tax of $15. Once we deduct the tax from the net profit before tax, we get NPAT, which in this case will be $35.
Why is NPAT an essential metric for companies?
NPAT is one of the most important metrics because companies ultimately exist to generate profits. Any time a company generates profit, it will need to pay tax, so NPAT represents the profit available to be shared with the business owners (the shareholders).
NPAT indicates the health of a company. Shareholders and analysts use it as a key parameter to evaluate business performance. Because one-off expenses are excluded, NPAT indicates how operationally efficient a business is. A higher NPAT, therefore, indicates greater efficiency.
The NPAT metric is also linked to dividends and share prices. Companies pay dividends 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 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, with the aim of increasing 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.
Decreased NPAT, on the other hand, can indicate a decline in sales, poorly managed expenses, excessive debt, or poor execution of management strategies.