NOPAT: What it is and how to calculate it

My Post (23).pngNOPAT 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 2019 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 2019, 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 2019, 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

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.

Comparing performance

Assume that Premier Furniture is a Seaside competitor, and also generated $1 million in revenue during 2019. 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 2019 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.

NOPAT margin

This margin is calculated as (NOPAT) / (Total revenue). The 2019 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 2019 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 labor costs. If Seaside can negotiate lower material costs or pay a lower hourly labor 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. – Read more

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Defining and implementing the accounting cycle for your business

My Post.pngManaging a small business is challenging. But if you can produce accurate accounting information, you can make better decisions and grow your business. When it comes to accounting, many business owners don’t know where to start. They need a roadmap that provides the steps required to create useful accounting data and financial statements. The accounting cycle is that roadmap.

What is the accounting cycle?

Accounting is the process of gathering information on business activity, posting transactions, and producing financial statements. The accounting cycle is a series of steps, completed in a specific order, that ends with a set of accurate financial statements. If you don’t follow each step in the cycle, you won’t produce accurate financial data.

Why is the accounting cycle important?

The accounting cycle can help you account for all financial transactions, protect assets from loss or theft, and report financial results to stakeholders. Small businesses often operate on narrow profit margins, and access to cash may be limited. These businesses have less room for error. Following the accounting cycle can help the business owner stay on track.

1. It protects your assets from theft

Assets are resources—vehicles, machinery, equipment—you use to generate sales and profits. Businesses must invest in asset purchases and maintenance. Without assets, businesses can’t operate. The accounting cycle protects assets from loss and theft. Imagine when a retail store purchases inventory, for example.

An accountant reviews the vendor’s invoice and the shipping receipt before increasing the inventory balance in the accounting records. Source documents support each accounting transaction, which reduces the risk of theft.

2. It helps you report financial results to stakeholders

Business owners may keep stakeholders informed for a variety of reasons. Stakeholders include employees, investors, creditors, regulators, and vendors. Investors want to know if the business is generating profits and that the business’s value is increasing. Creditors need to know if the company is generating enough cash to repay a loan. Vendors want to know if the business will continue to order goods and services and that the business can pay invoices on time.

The accounting cycle requires accountants to review the general ledger and the trial balance before using the information to create the financial statements. When a business owner can generate reliable financial statements, they can maintain good relationships with stakeholders.

How to implement each step in the accounting cycle

Every business should have a formal procedures manual that documents each step in the accounting cycle. The manual outlines each accounting task, how often the business must complete each task, and who is responsible for each task. Using a manual clarifies each process and reduces the risk of confusion.

Let’s look at an example. Outfield Sporting Goods follows the six steps in the accounting cycle.

1. Gather source documents

A source document is generated when an event happens in your business. Source documents include a receipt for a purchase or an invoice sent to a client.

On May 5, Outfield purchased $3,000 in leather materials to make baseball gloves. Their accountant reviewed the vendor’s invoice and the shipping receipt, which verifies that Outfield received the materials.

2. Determine the financial impact

Next, Outfield’s accountant must decide how the event impacts the accounting records. In this case, the inventory-material account increases by $3,000, and cash decreases by $3,000.

3. Post a journal entry

Outfield’s accountant records events the accounting records using journal entries. The journal entry includes the date, debit or credit, account number, account title, dollar amount, and a description of the transaction. The accountant enters this journal entry into the accounting system: – Read more

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5 ways to reduce small business debt

My Post (13).pngThe U.S. Small Business Administration (SBA) cites poor credit management, lack of money and personal use of business funds as some of the top reasons why small companies fail. Businesses that lack money to cover basic expenses such as rent and payroll can quickly spiral into delinquency or, worse, bankruptcy.

Moreover, the Bankruptcy Abuse and Prevention and Consumer Protection Act of 2005 has made it harder for small businesses to prove they should be cleared of all or some of their debts through Chapter 7 bankruptcy.

To ensure the overall financial health of your business, it’s imperative to know the various options available for methodically and effectively paying down business debt. From eliminating excess costs, to restructuring debts through a third party, being proactive and formulating a payback plan enables you to manage your bills before they become unmanageable.

1. Rework your business budget

Before attacking business debt, get a good handle of your current financial situation. If you’re falling behind on monthly payments, revisit your financial plan and adjust for unexpected changes in cash flow.

business budget helps identify your income sources, fixed costs and variable expenses. Budgeting also gets you into the habit of setting aside a monthly amount to pay your landlord, suppliers and creditors.

Seek professional advice from your accountant or contact non-profit associations like the SCORE Association for free business counseling, mentoring and online workshops on business budgeting. You can also automate the budgeting process using accounting software like QuickBooks to track money flowing in and out of your business. Ultimately, revisiting and revising your budget will help you better manage costs and form an action plan for reaching your debt-reduction goals.

2. Reduce business expenses

Next, take a look at your operating costs. Figure out which expenses you can axe versus services that are necessary for the daily operation of your business.

For example, do you pay for subscriptions that you use infrequently? Are there professional memberships you can suspend temporarily until you get your financial house back in order? Consult your accountant or use accounting software to forecast the financial impact of cutting costs in different areas of your business.

If you’re leasing an office, consider subletting unused space or downgrading to a smaller work area to reduce your monthly rent. You may also be able to negotiate reduced prices and flat rates with certain vendors. For example, software providers often provide discounts for bills paid annually versus month-to-month.

Your financial statements can be particularly helpful in pinpointing expenses contributing to your debt. Cutting costs may be the fastest way to increase cash flow and chip away at your liability before resorting to more drastic debt-reduction measures.

3. Increase customer sales

In addition to slashing costs, look at ways to increase customer sales that will boost your revenue. Offer mark-downs on merchandise and discounts on services, especially for loyal and repeat clients.

Additionally, ramp up accounts receivables by following-up on late payments from customers. For instance, presenting your clients with discounts for paying fees upfront can help improve your cash flow.

4. Communicate with creditors and lenders

If you find yourself falling behind on payments, prioritize debt payments to determine which creditors and suppliers must be paid first. Your cash flow statement should be particularly helpful for identifying delinquent accounts and missed payments. – Read more

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