NOPAT is Net Operating Profit After Tax. It shows a firm’s after-tax profits from day-to-day business operations. Analysts use the formula to compare business performance to past years, and to assess how a company is performing against its competitors.
This article uses an income statement to explain NOPAT, and to point out how the calculation differs from net income, EBIT, and other balances. You’ll learn how to calculate NOPAT, and how the formula can be used to make better decisions from financial reporting insights.
As an example throughout, meet Patty, the owner of Seaside Furniture, a manufacturing company. Here is Seaside’s 2020 income statement:
The income statement uses the term operating income, which also means operating profit. This discussion will use operating profit.
You’ll note that the operating profit formula ($200,000) differs from earnings before tax calculation ($184,000), and the reason for the difference helps to explain NOPAT.
What is NOPAT?
The NOPAT (Net Operating Profit After Tax) formula allows you to compare the profitability of two firms, assuming that neither business has any debt outstanding. This comparison is useful, because it focuses on profits from normal operations, without the impact of interest payments.
In 2020, Seaside had a $300,000, 6% loan outstanding, and paid interest expense on the loan. NOPAT removes non-operating income and expenses from earnings before tax. In 2020, Seaside had a $2,000 gain on sale of equipment, and $18,000 in interest expense, and both are in the non-operating category.
Non-operating activities are not generated from normal business operations. Seaside manufactures furniture, and selling a piece of equipment is not Seaside’s main business. Paying interest on a loan is also a non-operating activity.
As you see in the income statement, operating profit is calculated before the gain on sale and interest expense.
Assume that Premier Furniture is a Seaside competitor, and also generated $1 million in revenue during 2020. However, Premier carried $500,000 in debt. You can compare the profitability of Seaside and Premier by using operating profit.
Let’s assume that Jill owns a $10 million furniture manufacturing business, and is considering a purchase of either Seaside or Premier. To assess profitability, an investor may use NOPAT to compare the two firms.
Operating profit reveals how each company generates a profit from normal business activities. Gains and losses on asset sales are unusual, and the level of debt may vary greatly over time. NOPAT excludes these variables from the formula.
The operating profit and net income balances are also different.
NOPAT vs. net income
Net income includes all income and expenses, including taxes. Seaside’s net income includes the gain on equipment sale, interest expenses, and tax expenses. Operating profit does not include those three balances.
NOPAT vs. EBIT
EBIT refers to earnings before interest and taxes, and Seaside’s EBIT is slightly different than operating profit. Operating profit ($200,000) does not include the gain on equipment sale, interest expenses, and tax expenses. EBIT, however, would include the gain on sale, which would generate an EBIT balance of $202,000.
The NOPAT calculation includes the company’s tax rate.
How to calculate NOPAT
The NOPAT formula is (operating profit) X (1- tax rate). This calculation presents operating profit based on after-tax dollars.
Seaside’s 2020 calculation is ($200,000) X (1 -25% tax rate), or $150,000.
Is depreciation included in NOPAT?
Depreciation is included in the NOPAT calculation. Seaside posted $20,000 in depreciation, and the balance is included in total expenses. Note that depreciation is a non-cash expense. If Seaside pays $20,000 for a machine that is depreciated at a rate of $2,000 a year, the company does not write a check for the expense.
Some analysts prefer to use the NOPAT margin formula.
This margin is calculated as (NOPAT) / (Total revenue). The 2020 NOPAT margin for Seaside was ($150,000) / ($1,000,000), or 15%. The margin calculates the amount of profit earned on each dollar of sales. If a business can increase the margin, the firm is more profitable.
This formula is similar to profit margin, which is (net income) / (revenue). Seaside’s profit margin for 2020 was ($138,000) / ($1,000,00), or 13.8%. The profit margin ratio is lower, because net income includes more expenses than operating profit.
There are several reasons why NOPAT is a valuable tool for business decisions.
Why is NOPAT important?
NOPAT is a great indicator of how well a company uses assets to generate profits for core operations. Seaside can increase operating profit using these strategies:
- Sale price: Increasing sale prices can increase profits.
- Reduce costs: The firm’s $600,000 cost of goods sold balance, for example, includes material and labour costs. If Seaside can negotiate lower material costs or pay a lower hourly labour rate, profits will increase.
- Gain efficiency: Businesses can work more efficiently by embracing technology. Accounting software can help a firm post accounting transactions and create invoices in far less time, which reduces costs.
The NOPAT formula removes the impact of debt, and the tax savings of carrying debt. The $18,000 interest expense reduces Seaside’s tax liability. If the company didn’t carry debt, the tax expenses would be higher.
Operating profit also excludes non-operating gains and losses, which are unusual and cannot be predicted. By focusing on operating profit, an analyst can get a clear picture of profitability.
Generating cash inflows is just as important as earning a profit. Many profitable companies struggle to collect enough cash to operate the business each month. Free cash flow is a tool to assess cash management, and this metric differs from the NOPAT calculation.
NOPAT vs. unlevered free cash flow: what is the difference?
As discussed above, day-to-day business operations generate revenue, and eventually revenue is collected in cash. Unlevered free cash flow, or free cash flow to the firm, represents cash inflows after subtracting these costs:
- Depreciation expenses
- Working capital
- Capital investments
Seaside’s income statement includes depreciation expense and tax expense. However, it does not include line items for working capital or capital investments.
Understanding working capital
Working capital is defined as (current assets less current liabilities), and this formula measures a firm’s ability to generate sufficient cash inflows to operate in the short term (six to 12 months).
Current assets include cash, and assets that will be converted into cash within a year. Accounts receivable and inventory balances, for example, are expected to be collected in cash over a period of months.
Similarly, current liabilities include balances that must be paid within a year, including accounts payable and the current portion of long-term debt. If a business converted all current assets into cash, and used the cash to pay all current liabilities, any cash remaining equals working capital.
Financially healthy firms have a positive working capital balance, meaning that current assets are greater than current liabilities. Free cash flow assumes that working capital must be set aside for business operations, which is why the balance is subtracted from the cash flow total.
Every business must purchase new assets, and perform repair and maintenance on assets.
Why capital investments are necessary
Capital is defined as money invested in the company to purchase assets and to operate the business. Every firm uses assets to generate revenue, and assets must be properly maintained and eventually replaced. If you own a restaurant, you need ovens, refrigerators, and other equipment to create and serve food.
Free cash flow subtracts the dollars needed to maintain and replace assets. NOPAT does not account for working capital or capital spending, and the formula calculates profitability before considering depreciation expense and tax expenses.
Some analysts prefer the free cash flow calculation, which set aside dollars required for working capital and capital spending.
You have dozens of financial reports that may help you manage your business, and the amount of data may seem overwhelming. So where do you go from here?
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