NOPAT stands for “net operating profit after taxes.” This figure is used to determine how much economic profit has been achieved. There are a series of steps that you can take to determine the NOPAT figure from an income statement.
It is important to remember that different calculation yields will generate different levels of precision when determining your final NOPAT number. If you want a very precise number, you may need 150+ adjustments to the income statement to ensure the quality you want.
For a basic calculation, however, you can follow this process while still maintaining an acceptable level of precision.
The Three Steps to Calculating NOPAT
You have three basic steps that must be followed if you’re determining NOPAT from an income statement.
First, you must begin with the EBIT figure. EBIT stands for “earnings before interest and taxes.” If you’re unable to find an EBIT figure, you can take something that is close to it. Look for the line in the income statement that comes closest to the EBIT to begin your calculation.
For some income statements, that means taking the income figure that comes before minority interests and income taxes. Do not take the net income figure from the income statement to calculate NOPAT.
Take the “almost EBIT” figure, then add or subtract items that were not calculated into that figure which could take you to an EBIT. In this situation, you would need to add interest expanses back into the figure. You want to make sure that your NOPAT calculation is able to capture the profits which accrue for everyone.
Then you must make key adjustments to these principles.
- There must be an elimination of accounting distortions, which means converting accrual to cash.
- Certain expenses must be reclassified as investments, capitalizing them to the balance sheet.
It is important to remember that if you are making a capitalizing adjustment for NOPAT, then you are doing the same thing for invested capital. You must match each income statement with a balance sheet adjustment to ensure that your calculation will be accurate.
Companies are permitted to treat an operating lease as an expense, which means no liability is placed for them on a balance sheet. That is different than how a capital lease is treated. You must place them back onto the balance sheet for the NOPAT calculation to be accurate.
Anything that would be considered off-sheet financing, either positive or negative, must be added back into the income statement before calculating NOPAT. Otherwise, the economic impact of these implied or real interest or income from the leases will not be included, which negates the validity of the NOPAT once the calculation is finalized.
If this information is not available to you, a reasonable estimate is still better than nothing at all. Every company in the U.S. is required to disclose their future stream of minimum obligations under their operating leases. Once you’ve accounted for discounting, you can use this figure to estimate what the current impact happens to be.
The Issue of Bad Debt and the NOPAT Calculation
When viewing an income statement to calculate NOPAT, you must pay close attention to allowances which are made for bad debt. A general rule of thumb for bad debt budgeting is to set 6% aside to cover this issue.
By increasing this account on the income statement, it creates an appearance that cash has been reduced. That is not accurate. It actually shows a decision to anticipate future cash losses which have not yet occurred.
Think of it like a receivable that has not yet been received. If you’ve billed a customer for $1,000 and you know they’re good for it, your profits are still reduced on the books until that money is physically received. The same is true for bad debt. It isn’t an actual debt until it becomes one. You must add this figure back into your income before calculating NOPAT for it to be accurate.
How to Deduct Cash Operating Taxes
Once you’ve made those adjustments, you must then subtract the cash operating taxes. This is the last step necessary to determine NOPAT.
Cash operating taxes are the taxes which a company would pay with cash out of their net operating profits. There are a couple ways you can figure out what amount should be deducted to reach the final figure.
The easiest method is to substitute the taxes which were reported by the company. That will produce a usable economic figure, though it wouldn’t be a “pure” NOPAT. Because a company may keep their tax reports separate from their financial statements, what is paid in taxes can be different than what is eventually recorded as a tax expense.
By using cash taxes with the NOPAT calculation, you can capture a true return that is created from the actual cash investments that are made. That means your final calculation won’t be seen as a discrepancy from reported taxes, which may be different.
Both are legitimate options that can be used, however, so take whatever figure is easiest to obtain. If cash operating taxes is reported, use that figure over reported taxes for better accuracy.
A Final Summary of NOPAT
When determining your cash operating tax or operating lease figures, there can be several calculations which must take place before you reach the final NOPAT figure. The process for NOPAT from an income statement will be the same, no matter how complicated those process calculations happen to be.
You must begin with the EBIT. Then you make the key adjustments to that figure to ensure that the numbers are a true reflection of economic activity. Then you subtract the real or estimated cash operating taxes that would have been paid under the net operating profit figure, even if there are no taxes reported on your documentation.
This guide is not intended to be a comprehensive set of instructions to determine every potential NOPAT outcome. It is a review of the critical factors that are necessary for consistency across the basic calculations that are necessary. Through this process, you will be able to obtain a reasonable idea of the economic profits generated by an organization from figures reported on the income statement.