Investors have two options. They can either look at their net operating profit after tax, which is referred to as NOPAT, or they can look at their net income.
Net income is calculated by deducting all expenses that take place over the course of the year. Expenses include non-cash items, such as depreciation. Taxes and interest are also included in this classification.
NOPAT is calculated by using the operating income only. It is basically the earnings before interest and taxes (EBIT) but adjusted for the impact of the tax structure.
This is the equation that helps you determine NOPAT: (net operating income) x (1-tax rate).
NOPAT does not consider associated interest payments or account debt.
Here’s an example of how this would work.
Let’s say that a company reports revenues of $1 million. The cost of goods sold is 50% of that, so it is listed at $500,000. Labor is an expense listed at $300,000. Now let’s say you have an administrative expense of $50,000, an interest expense of $20,000, and a 36% tax rate.
When you factor in all the expenses, you would have an operating income of $150,000 off of that $1 million. After taxes and interest, you would have a net income of $83,200.
If you used the NOPAT calculation, however, you would come to a figure of $96,000. That is because you would have ($150,000) x (1 – 0.36).
Key Differences between NOPAT vs Net Income
1. NOPAT is a measurement of operational efficiency.
When investors know their net income, then it becomes easy to know what NOPAT will be. If you know NOPAT, however, then to ascertain the net income, one must know what the interest rate on any debt happens to be. That is why NOPAT is often used for comparison purposes. It is able to measure the effectiveness of companies within the same industry that may use very different financial structures.
2. NOPAT excludes interest expenses.
When you are taking net income into account, you are able to take interest expenses on debt and deduct them from the final figure. This does not happen when you are calculating NOPAT. It is a good way to understand how the company is profitable because the focus is on the earnings which are generated by company operations. Through this process, you can then calculate your EVA – economic value added.
3. Net income can be the same as NOPAT.
If there are no financing costs for a company, or there is no interest income to report, then NOPAT will be the same as the net income. For companies that have very little debt, or no debt at all, calculating the net income is usually a sufficient result to determine the organizational results which were achieved.
4. Net income evaluates the company’s performance.
NOPAT is an after-tax calculation that allows you to see what you have left at the end of the day. Net income is what is left after all the costs and expenses are deducted. It is the bottom line for the shareholder’s equity, which offers a net increase or loss depending upon the performance the company was able to achieve.
When NOPAT Is Used for Financial Modeling
NOPAT is used as the starting point to calculate the unlevered free cash flow for an organization. The most common approach to the valuation process is to calculate the value of the enterprise, not its equity value, which makes it possible to ignore the capital structure of this business.
That means the assets of the company are the only thing that is used to determine its overall value.
The issue that sometimes comes up is the fact that NOPAT doesn’t consider any changes which occur in a company’s net working capital accounts. Inventory, accounts payable, and accounts receivable are just three examples of what the calculation ignores. Amortization and depreciation are not factors in the calculation either.
An actual cash expense is not included in the NOPAT calculation either.
What Are the Advantages of Net Income?
The net income of a business is a calculation of all revenues, minus all expenses. The sources of revenue might include direct sales and operational income, along with miscellaneous activities, like income earned from a lawsuit settlement. Net income includes one-time items for purchases and income receives.
Expenses that are factored into the net income calculation include employee wages, the cost of materials, and interest expenses on any loans that have been acquired.
When the net income is produced by a company, it offers the general public a level of added value because there is more visibility. Although it may not track the cash value of the company, most profits get invested back into a business to help it grow anyway. That is why many SMBs and SMEs finish the year with less cash than they had at the beginning of the year.
That is why all sources of revenues and expenses are considered when calculating the net income.
Which Is Better for the Investor: NOPAT or Net Income?
For the investor, NOPAT is the better figure to use when trying to make an investment decision. That is because the NOPAT calculation is a measurement of the profits that a company earns, excluding the tax and cost benefits which come with debt financing that supports the capital structure of the organization.
It should be noted that NOPAT is not overshadowed by the leveraging decisions a company may make, or by the amount that is available in an active loan. In the U.S., interest payments are a pre-tax expense, which means NOPAT is able to assess the operations of the company and its profitability in a clearer way for the investor.
In a perfect world, the investor would take time to take both NOPAT and net income into account when making an investment decision. If only one figure can be calculated, then NOPAT should be the one looked at since it provides the best look at the overall operations of the company.