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Key items below the profit before tax level

Jun 4, 2009

In the previous article of this series, we had discussed about depreciation and interest expenses. In today's article, we will take a look at the items that come below these taxes, net profits and appropriation. Taxes: There are different types of taxes that a company pays. The ones that are commonly found in annual reports are current income tax, fringe benefit tax, wealth tax and deferred income tax.

Corporate income tax is the tax which a company pays on the profits it makes. Currently, the domestic corporate income tax rate stands at 30% (A surcharge of 10% of the income tax is levied, if the taxable income exceeds Rs 1 m). It may be noted that the tax structure for foreign companies operating in India is different.

After adding other income and deducting the interest and depreciation charges from the operating profits, we arrive at a number which is known as the profit before tax (PBT). On dividing the current income tax (for the particular year) by the PBT (also known as the net taxable income) we get a figure which is called the 'effective tax rate'.

Fringe benefit tax is the tax which a company pays on certain benefits which its employees get. This includes items such as employee stock options (ESOPs), expenses on travel, entertainment, amongst others. It may be noted that the employer needs to cover the cost of these items for them to be accounted as a fringe benefits.

Wealth tax is levied on the benefits derived from ownership of certain non-productive assets that a company owns. As such, assets like shares, debentures, bank deposits and investments in mutual funds, being productive assets, are exempt from wealth tax. Non-productive assets include jewellery, bullion, motorcars, aircraft and urban land, amongst others.

The need for deferred tax accounting arises because companies often postpone or pre-pay taxes on profits pertaining to a particular period. It may be noted that when a company reports its profits/losses, it is not necessary that they match the profits the taxman lays claim to. As such, if a company prepays taxes relating to the future years, it will show up as deferred tax assets in the profit and loss account. Similarly, if a company creates a provision for deferred tax liability, it shows that it has postponed part of the tax of that period's transactions to the future.

Net profits: After deducting the taxes from the PBT, we arrive at the profit after tax, which is also called the net profit. One can say that the net profit is probably one of the most sought after figures in the analyst community. It is the figure that each analyst tries to derive using all the knowledge he or she possesses. After all, the earning per share or the EPS is attained by dividing the net profits by the shares outstanding.

Net profit margin is a measurement of what proportion of a company's revenue is leftover after paying for costs of production / services and costs such as depreciation on assets and finances its takes to run or expand the company. A higher net profit margin allows the company to pay out higher amounts of dividends or plough back higher amount of money back into the business. Net profit margin is calculated by dividing the net profits (for a particular period) by the net sales of that respective period.

Net profit margins = (Profit before tax- Tax)/ Net sales * 100

Appropriation: A company can do two things with the profits that it earns. It can either invest it back into the company (into reserves and surplus) and/or pay out the amount as dividend. In addition, the tax on dividends is also included here. To get a better understanding of how this functions, we can take a look at the image below.

Source: Britannia FY08 annual report.

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