Effective Tax Rate: Computing the Rate a Company Actually Bore

The effective tax rate is the total tax expense divided by the profit before tax, expressed as a percentage: the rate the reported profit actually bore. The cash tax rate uses only the current tax, the part charged on this year's taxable profit, over the same profit figure. Computed together, the two rates show how much of this year's tax charge was paid and how much was deferred.

Here is what sits underneath that. One profit figure, two tax figures, and the same division performed twice. The statement of profit and lossThe statement reporting what a business earned and spent across a period. In many places the same statement is called the income statement. prints the profit and the whole tax charge on its faceThe main printed statement itself, as opposed to the numbered notes that sit behind it and break its lines into parts.. The note behind the tax line splits that charge into two amounts. The whole charge divided by the profit gives the first rate. The first of the two note amounts divided by the same profit gives the second. The arithmetic is two divisions. The work lies in reading each of the three inputs off the right printed line.

Each of the three inputs has one exact line it is read from, and Anjani Stationers Private Limited, an invented stationer, supplies the year two figures the two divisions below run on: 21.1 per cent from the whole charge, 16.3 per cent from the current tax alone, and the 26.7 per cent that the wrong denominator produces. Why any rate turned out the way it did is covered separately.

What does the effective tax rate measure?

The effective tax rate measures the share of the profit before tax that the tax charge took. The rate is nothing more than that share, and saying it as a share rather than as an amount is the whole reason anybody bothers. Suppose a neighbour who runs a printing shop reports having paid Rs 1,20,000 of tax last year. Nothing can be done with that sentence. The sentence becomes usable the moment she adds what she earned before the tax was taken: on Rs 6,00,000 the figure is one rate, on Rs 12,00,000 it is half that rate, and only the division settles which of the two it is. Every comparison anybody wants to make, between one year and the next or between two businesses of very different sizes, needs the amount converted into a share first.

The effective tax rate is not a rate anybody chose, it is a division performed after the year is over, and both of its inputs are already printed on the statement before the work begins. That rules several things out. No rate is printed anywhere in the accounts, so none is being looked for there. No percentage is being applied to a profit figure to see what the tax should have been. Two amounts that already exist, one above the other on the same statement, are being turned into a percentage. For Anjani Stationers in year two those two amounts are a total tax expenseThe single charge for tax reported for the period, before it is broken into its parts in the note behind it. of Rs 8,00,000 and a profit before tax of Rs 38,00,000, and the division gives 21.1 per cent.

What goes in the numerator, and where is it found?

The total tax expense, and it is printed on the face of the statement of profit and loss, on the line that sits between profit before tax and profit after tax. The face is the only place to look. The caption varies a little between preparers: it may read Tax expense, Total tax expense, or a heading called Tax expense with two indented rows underneath it that are then totalled. Where the two rows appear on the face rather than in the note, the required number is their total, the amount actually deducted to reach profit after tax.

The numerator is a printed line and not a computed one, so the first check on any effective tax rate is that the amount divided by was lifted straight off the statement rather than assembled from somewhere else. Three amounts on a set of accounts sound alike and are not the same figure. The first is the total tax expense on the face, the numerator of the effective tax rate. The second is the current taxThe tax worked out on the period's taxable profit under the tax rules for that period, reported as one of the parts of the charge. in the note behind that line, the numerator of the cash tax rate. The third is tax paid, reported in the cash flow statement. Tax paid is the amount remitted during the year, and it belongs to neither computation. Picking the wrong one of those three leaves the arithmetic working perfectly and answering a question that was not asked.

What goes in the denominator, and where is it found?

The profit before taxThe subtotal reached after every cost of trading, funding and asset use has been deducted, and before the tax charge is taken off., and it is the subtotal printed immediately above the tax line just used. The subtotal is captioned profit before tax on most Indian statements and earnings before tax on many others, and the two captions mean the same subtotal in the same position. Where the statement shows exceptional items or a share of results from other businesses between the subtotal and the tax line, take the figure the tax line is actually deducted from. The charge was levied against that profit and no other.

The two inputs sit one line apart on the same statement, and the row that ruins the computation sits one line the other side of the tax line. A single row separates the right divisor from the wrong one, and the wrong denominatorThe number underneath the line in a division, the quantity the top number is being divided by. is the single most common fault in this arithmetic. Work both versions for Anjani Stationers and look at the difference. Rs 8,00,000 over the profit before tax of Rs 38,00,000 is 21.1 per cent. Rs 8,00,000 over the profit after tax of Rs 30,00,000 is 26.7 per cent. Profit after tax has already had that same Rs 8,00,000 taken out of it, so the second figure is not a slightly worse answer but an answer to a different question. Dividing a charge by what was left after the charge always reads high, and it reads high by more the larger the charge is.

Revenue is the third denominator people reach for when they cannot find a profit line they trust. Rs 8,00,000 over Anjani Stationers' revenue of Rs 2,70,00,000 is 3.0 per cent. The 3.0 per cent is not wrong as arithmetic, and it is not an effective tax rate. A charge measured against sales is not a charge measured against the profit it was levied on. Keep the name for the division that uses profit before tax underneath, and describe anything else by what it actually divides.

What is the cash tax rate, and where do its inputs come from?

The cash tax rate is the same division with a smaller numerator. Keep the profit before tax exactly where it was and replace the whole charge with the current tax alone. The current tax is found in the note behind the tax line rather than on the face. Open the notesThe numbered explanations printed after the statements, where a single printed line is broken into the parts that make it up., find the one the tax line is cross referenced to, and it will show the charge split into two named amounts that add back to the face figure. The first is current tax. The second is deferred taxA charge or credit arising because the accounts and the tax computation take the same item into different periods., and it serves only as a check that the two add to the total already in hand.

Both rates stand on the same denominator, so the only thing that separates them is which numerator was taken, and that single choice is what makes the two figures comparable at all. Breaking that discipline has an immediate consequence. Current tax over profit before tax gives one reading of the same year. Current tax over some other profit measure gives two rates that no longer share a base, and two rates without a shared base cannot be set beside each other. Anjani Stationers' note behind the tax line shows current tax of Rs 6,20,000 and a deferred tax charge of Rs 1,80,000, and the two add to the Rs 8,00,000 on the face. Rs 6,20,000 over Rs 38,00,000 is 16.3 per cent.

The name of this rate invites a wrong assumption, so one precision is worth carrying away. The current tax figure is the charge worked out on this year's taxable profitThe profit figure the tax computation works from, arrived at under tax rules rather than under accounting rules.. The current tax is not a receipt. The amount actually remitted to the tax authority during the year, instalments for this year and settlements for earlier ones together, is reported as tax paid in the cash flow statement. Tax paid is the line to open when the remittance itself is wanted. For Anjani Stationers the current tax and the tax paid are taken as the same amount, and the arithmetic stays clean for it. In a real set of accounts the two frequently differ.

What do Anjani Stationers' two rates come to?

Here is the whole computation with nothing hidden, laid out as the three inputs, their sources and the two divisions they feed. The middle column is the instruction: it names where the figure sits in the printed accounts, and nothing more than that.

The distance between 21.1 per cent and 16.3 per cent is not a rounding artefact or a second opinion, it is the Rs 1,80,000 of deferred tax inside the charge, expressed against the same profit as 4.7 percentage points. That identity is worth holding onto because it makes the pair self checking. The two rates share a denominator, so the gap between them can only be the difference between the two numerators, and Rs 8,00,000 less Rs 6,20,000 is Rs 1,80,000. Rs 1,80,000 divided by Rs 38,00,000 is 4.7 per cent. If the two computed rates differ by more or less than the deferred amount over the same profit, one of the three inputs came off the wrong line and the pair will not reconcile.

Rounding is the one place this arithmetic embarrasses people, so it deserves attention as the figures are written down. Carried to more decimals the two rates are 21.05 and 16.32, and the difference is 4.74. Rounding each rate to one decimal first and subtracting gives 4.8, and 4.8 does not match the 4.7 obtained by dividing the deferred amount directly. Neither figure is a mistake. Computed from the amounts rather than from the rounded rates, and with the convention stated, the pair agrees with itself every time.

With no part of the charge deferred, the current tax is the whole Rs 8,00,000 and the two rates land on the same 21.1 per cent, with no gap at all. At the reported split of Rs 1,80,000 deferred the pair is 21.1 and 16.3. At Rs 4,00,000 deferred the current tax is Rs 4,00,000 and the cash rate reads 10.5 per cent. At Rs 6,00,000 deferred it reads 5.3 per cent, and with the whole charge deferred the current tax is nil and the cash rate reads 0.0 per cent. Neither input of the effective tax rate changed, so it holds at 21.1 per cent through every one of those splits. Nothing shows more plainly that the two rates are answering different questions from the same accounts.

How do the two finished rates get used together?

Step out of the arithmetic for a moment. These two rates are not computed for their own sake. The people who compute them then have to do something, and each of those people does something different with the pair. The current tax is the part of the charge that turns into a payment obligation within the ordinary run of the year, and a lender is sizing obligations, so a credit officer sizing a working facility wants the cash tax rate. The effective tax rate is the figure that is comparable across businesses and across years, so an analyst comparing two businesses of different sizes wants that one. A household budgeting around a small business needs both. Anjani Kulkarni, deciding what to draw from Anjani Stationers, is in that position: one rate tells her what the year's reported profit carried, the other tells her what is likely to leave.

The pair is a routing instruction rather than a verdict: it tells the reader whether the next thing to open is the face of the statement or the note behind the tax line. Where the two rates are close together, the charge is almost all current and the note has little to add, so the reader stays on the face. Where they are far apart, most of what was charged this year has not been paid this year. The deferred amount is printed and broken down in the note behind the tax line, so the note is the next thing to turn to. The pair is still only a statement about where to look. The meaning of the deferred amount, and the reasons an effective rate sits where it sits, are separate questions covered separately.

Anjani Stationers Private Limited and Anjani Kulkarni are invented.
Educational material. Not advice on any investment, tax, budget or market position.