5. Interest, Taxes and Net Profit

 
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Overview

By subtracting interest and taxes from EBIT, we arrive at net profit - a great indicator of MarkerCo's performance over the past 4 years

Lesson Notes

Interest, Taxes and Net Profit

- Interest payments are included after operating expenses on the income statement
- Interest is paid on loans currently held by the company
- Taxes vary by region, the United States in particular has very high taxes on company earnings
- Subtracting Interest and Taxes from EBIT leaves us with Net Profit
- Interest Coverage Ratio = EBIT / Interest Expense

Net Profit Margin

- Net Profit Margin = Net Profit / Revenue
- Net Profit Margin is a useful measure of profitability for a company
- A Net Profit Margin of greater than 20% signals a strong competitive advantage

Transcript

Below EBIT on the Income Statement, we've a line called net financing costs. This corresponds to the interest paid or received on loans over the period in question. As MarkerCo has little or no debt to speak of, the interest payments for the past 4 years have been negligible. In general, this won't be the case. Companies will often have some debt that will require an interest repayment. As you may have seen in the valuation course, interest can act as a tax shield, because it is paid before taxes are taken into account. Interest paid is considered a financing cost, not an operating cost, so it's isolated on its own in the bonds sheet. Companies in the same industry can have very different levels of interest payments. As well as offering a tax shield, interest payments put additional pressure on maintaining your net profit. This can provide great discipline in a company, but also limit the company's capacity to spend. For example, if MarkerCo had high interest payments over the past 4 years, it may not have been able to spend more on sales and marketing expenses to grow revenue. When analyzing financing costs in the Income Statement, you compare to EBIT to measure what's called the interest coverage ratio. This measures how hard it will be for a company to continue servicing its debt. A coverage ratio of 4 or above is generally considered safe. However some industries will have higher interest coverage ratios than others. For example, investment banks. Typically, investment banks will have an interest coverage ratio in the region of 1.5, whereas technology companies may have a coverage ratio of above 7. After net financing costs, the last payment to be made are income taxes. Income taxes can have a huge impact on profits, especially in certain jurisdictions like North America, where the corporation tax is around 35 percent. In Ireland, where MarkerCo is based, the corporation tax is 12.5 percent. As a result, net profit for MarkerCo will be much higher regardless of performance, by just basing the company in a different jurisdiction. This clearly shows you how companies can save lots of money by declaring revenue overseas in jurisdictions with lower tax rates. Once we subtract taxes, the Income Statement ends with net profit for the company. To calculate the net profit margin, we divide the net profit by revenue to calculate this profitability metric. So otherwise, equals, select net profit, and divide by revenue.

I'll copy across, Ctrl + R, and write net profit margin.

As you can see from this calculation, the net profit margin has grown over the past 4 years. Which is great, because the company has managed to grow its revenue and its profitability margin at the same time. This means that the company is in a very healthy financial position in the market. Typically, without specifying an industry, companies with a net profit margin of greater than 20 percent, have a strong competitive position. As you've probably noticed over the past few lessons, we need to calculate a lot of ratios when examining the Income Statement. There is a way of converting the Income Statement entirely into ratios, which I'll show you in the next lesson called The Common-Size Income Statement.