Net operating profit after tax (NOPAT) is an important profitability and efficiency metric. It tells us about the operational efficiency of a business.
NOPAT can be used to analyze the impact of debt financing (leverage) on the profits of a business. Thus, it is a core measure of the profits generated through the operations of the company.
Let us discuss what is NOPAT and how to calculate it.
What is Net Operating Profit After Tax (NOPAT)?
Net operating profit after tax (NOPAT) represents the net profits of a company without debt and interest expenses. It also excludes the tax shelter or tax savings from interest payments on debt.
NOPAT is a measure of operating the profitability of a business without interest and tax charges. It simply means to measure the profitability of a company without using debt leverage.
A business can be leveraged through equity and debt. Debt comes with interest costs and offers additional tax savings on this interest paid. It means the net profits of companies with and without debt would be different considering everything else equal.
Another important aspect of NOPAT is its exclusion of one-time and non-recurring gains and losses from a company’s net profits. For example, gains from depreciation adjustments are considered non-recurring gains.
Thus, NOPAT aims to reveal the actual operating income of a business that comes mainly from its operations. It offers a more realistic and refined profitability measure by taking operating profit and net income one step ahead.
How to Calculate NOPAT?
Net operating profit after tax considers the operating profit of a company minus tax savings on interest payments. There are two approaches to calculating NOPAT.
The simple formula to calculate NOPAT is:
NOPAT = Operating Profit × (1- Tax Rate)
Here, operating profit is gross profit minus the operating expenses of a business.
The term (1- Tax Rate) calculates the net profit after paying taxes. Therefore, the formula calculates profits net of tax savings made on interest payments.
The longer form is a more complex but accurate method to calculate NOPAT.
NOPAT = (Net Income – Non-Operating Gains + Non-Operating Losses + taxes + Interest) × (1 – tax rate)
We can NOPAT using a step-by-step approach.
STEP 01:
The first step is to calculate the net profit of the business. Net profit can be calculated by starting from sales revenue. Deduct the cost of goods sold to get gross profit.
Then deduct all operating expenses to get the net income of your business.
STEP 02:
The NOPAT formula excludes one-time gains from net profit. Therefore, if there are any gains that are non-recurring, you should deduct them from net profits.
Similarly, a business may face a non-recurring loss in a fiscal year. Add back that non-operating loss to net profits in this step too.
This step aims to eliminate the impact of non-operating income from net profits. Thus, it provides profits generated through primary operations only.
STEP 03:
Then, calculate your tax expenses. Deduct your interest costs from net profits before applying the effective tax rates.
Then, apply the effective tax rate to calculate the tax expense for the year.
STEP 04:
The tax and interest costs should be added back to the operating income figure calculated in the first step.
This way, the resulting profit amount will be net of interest and tax costs since the multiplier already includes the tax rate.
STEP 05:
The final step is to multiply the calculated profit with the tax multiplier (1 – tax rate). This step will provide net operating profit after tax of the business.
Example
Suppose a company ABC has the following data available through its financial statements for the latest financial year.
Sales Revenue = $ 500,000 COGS = $ 80,000 Labor= $ 50,000
General and Admin Expenses = $ 40,000.
Net Profit = 500,000 – (80,000 + 50,000 + 40,000) = $ 330,000
It paid interest expense of $ 50,000 on its debt. Therefore,
Profit Before Tax = $ 330,000 – 50,000 = $ 280,000.
The corporate tax rate is 30%. Therefore,
Tax Charges = $ 280,000 × 30% = $ 84,000.
ABC company incurred non-operating losses on adjustments of Goodwill of $ 50,000. It had one-time and non-operating gains of $ 30,000 as well.
Now, we can calculate NOPAT for ABC company by using the available data in the formula.
NOPAT = (Net Income – Non-Operating Gains + Non-Operating Losses + taxes + Interest) × (1 – tax rate)
NOPAT = (280,000 – 30,000 + 50,000 + 84,000 + 50,000) × (1 – 30%)
NOPAT = $434,000 × 0.7 = $ 303,800.
Important Considerations with NOPAT
Using the longer form of the NOPAT formula, we can interpret important results.
NOPAT aims to calculate the profits generated through the core activities of the business. It eliminates the impact of debt financing and the tax savings that come with it.
It can be a good tool that can help compare two companies in the same industry with different leverage levels. Once we exclude the debt financing impact from the profits of both companies, the net profit would offer a clearer picture of the operating efficiencies of these companies.
It means NOPAT can offer an overview of the operating efficiency of a business. It can also be considered a good measure of the return on equity resources of a business.
Uses of NOPAT
NOPAT is an important performance indicator of a business. It takes the net profit and profit margins to the next step. Different stakeholders of a business can use NOPAT to analyze different performance aspects.
Creditors and Lenders
NOPAT tells creditors and lenders about the debt repaying abilities of a business. Since it is a measure of profitability that shows profits from the core operations of the business, it is a better analytical measure for lenders.
Managers
NOPAT is a good indicator of the operational efficiency of a business. Managers and executives can use this measure to decide important matters of operational efficiency.
For instance, managers can decide between raising prices or measures to improve internal efficiency.
Shareholders and Investors
NOPAT provides a useful metric to measure return on investment as well. Shareholders and investors can analyze the net profitability of a business using NOPAT rather than operating income or EBIT.
Pros and Cons of Using NOPAT
NOPAT offers some advantages and disadvantages as compared to other profitability metrics.
Advantages of using NOPAT include:
- It excludes the effects of excessive leverage or debt financing of a business. Thus, it offers a better profitability measure.
- It can be used to compare two businesses with different leverage levels in the same industry.
- It helps managers understand the operational efficiency and profitability of the business.
- NOPAT is widely used in business valuation methods.
Some disadvantages of using NOPAT include:
- Discarding the effects of debt financing may not be a useful tactic for particular industries.
- Investors may not realize an accurate situation without considering the impact of controlled leverage levels.
- The comparison of two companies may not be made for the solvency evaluations without considering other financial performance metrics.
NOPAT and Free Cash Flow of a Company
NOPAT is an important metric for calculating the free cash flows (FCFs) of a business. It can be used as a starting point to calculate the FCF in the financial modeling analysis.
Free cash flows can be calculated by using the NOPAT figure and deducting changes in the working capital. A similar measure to FCF is the economic cash flow of a business. It uses NOPAT minus the working capital figure of the business.
NOPAT Vs EBIT
EBIT stands for earnings before interest and taxes. It is a profitability measure of a business before paying interest expenses and taxes.
It looks a similar measure to NOPAT but it comes with some differences.
EBIT can be compared with the operating income of a business. It is a profitability measure of the company that shows the income generated from operations and before serving debt and tax charges.
On the other hand, NOPAT excludes the impact of leverage on the profits of a company. It considers the impacts of debt financing and the tax shelter that comes through deductions of interest expenses from operating profits.
NOPAT Vs Net Income
Net income is a relatively close measure of profit to NOPAT. It is the bottom line of a business in any case.
Net income is the profit of a business after paying all types of expenses including operating, non-operating, interest, and tax expenses. Therefore, it is the net of all costs incurred by a business.
Net income offers useful information about the solvency of a business. It helps understand the debt serving abilities of the business.
