The pre-tax return on networth formula is a simple financial ratio that tells you how much profit a business earned, before tax, compared with the owners’ stake in it. It is used mostly in small business analysis and in older textbooks, and it is closely related to the more common return on equity.
Pre-tax return on networth formula: the formula
Pre-tax return on net worth equals pre-tax profit divided by net worth, multiplied by 100 to give a percentage.
In symbols: Return on net worth (pre-tax) = (Profit before tax ÷ Net worth) × 100.
Net worth in this context is the owners’ equity: total assets minus total liabilities. Profit before tax is the profit shown on the income statement after all operating costs and interest, but before income tax is deducted.
A worked example
Suppose a small company earned 60,000 in profit before tax during the year. On its balance sheet, it has 400,000 in assets and 150,000 in liabilities, so net worth is 250,000.
The ratio is 60,000 divided by 250,000, which is 0.24, or 24 percent. That means the business earned 24 cents in pre-tax profit for each dollar of owners’ equity.
The numbers are made up for illustration only.
What it tells you
A higher ratio generally means that the business is using its owners’ money productively. It can help you compare two similar companies or follow the same company over several years. For example, if the ratio falls from 24 percent to 12 percent, you would ask whether profit dropped or whether net worth grew faster than profit.
How it differs from return on equity
Return on equity, or ROE, is usually calculated with net profit after tax in the numerator. The pre-tax version leaves out tax, which makes it easier to compare companies in different tax situations, but it overstates what owners actually keep. Both use the same denominator, equity.
Using average net worth
Many analysts use the average of opening and closing net worth for the year instead of the year-end figure, especially if net worth changed a lot. This avoids distortions if the business raised capital or paid large dividends during the year.
Limits of the ratio
A small base can inflate it
If a company has very little equity because it has borrowed heavily, the ratio can look impressive but conceal risk.
Accounting choices matter
How assets are valued and how costs are recognised can change both profit and net worth.
It is a snapshot
One year can be unusual. Look at several years and compare with similar businesses in the same industry.
Personal use
Some people apply the same idea to their own finances, dividing their annual investment income or gain, before tax, by their net worth, to get a rough sense of the return on everything they own. This is not a standard accounting ratio, so define it clearly if you use it, and compare like with like.
Questions readers ask
Is a higher number always better?
Not always. It may reflect high debt or a one-off gain.
Which profit figure should I use?
For the pre-tax version, use profit before income tax, after interest.
Where do I find the numbers?
In a company’s income statement and balance sheet.
How lenders and investors use it
Banks that lend to small businesses often look at profitability ratios along with debt measures. A business with a strong return on net worth and moderate debt is usually viewed as healthier than one with the same return and heavy borrowing. Owners can use the ratio to decide whether to reinvest profits or take money out, by comparing it with what they could earn elsewhere. For example, if a business earns 24 percent before tax on the money tied up in it, an owner might ask whether a safer investment with a lower return would be a better use of that capital once risk is taken into account. The ratio does not give the answer, but it frames the question clearly and can be reviewed each year as part of the annual accounts.
Tips for getting reliable inputs
Use the same accounting period for profit and net worth. Check that one-off items, such as the sale of an asset, are treated consistently. And if you are comparing companies, make sure you use the same definition of profit for each.
*This article is for general education, not financial advice. Examples use made-up numbers.*
More like this: browse our Finance & Money section. For background, see the Wikipedia entry.
