Net operating profit after taxes (NOPAT) is after-tax operating cash generated by a company and available for all investors—both shareholders and debtholders. This metric is used in value-based management as an indicator of corporate performance because it is more accurate than earnings before interest and taxes (EBIT), also known as operating income.
If a rough appraisal of NOPAT is needed, the calculation formula is as follows:
NOPAT = EBIT ×(1-Tax Rate)
However, if a precise appraisal is needed, calculating NOPAT becomes much more complicated. To get the exact number, we can use either the operating or financing approach. Note that both of them give equal results!
EBIT → Adjustments → NOPAT
Net Income → Adjustments → NOPAT
Regardless of which approach is used, the following adjustments must be made to get an accurate appraisal of NOPAT.
If a business has assets held for sale, any income or loss generated by them should be accounted for separately. To avoid this distortion, we should exclude any income or loss from discontinued operations because they will not recur in the future.
Asset write-downs or asset impairments reduce the assets’ value declared in a balance sheet and destroy shareholder equity. If such asset write-downs are declared as operating expenses, they should be excluded.
Any change in the total value of off-balance sheet reserves should be added to the net operating profit after taxes. In other words, any increase in total reserves leads to an increase in NOPAT and vice versa, e.g., the allowance for doubtful accounts is an example of off-balance sheet reserve.
Unlike a capital lease, an operating lease is an example of off-balance sheet financing. According to accounting standards, assets provided by the lessor under operating leases are kept on the lessor’s balance sheet, but they generate economic profit in the same way as assets under a capital lease. So we should add back the implied interest.
Deferred tax liabilities arise due to differences in tax policy and accounting standards, when taxable income is less then the income reported in financial statements. In other words, it is an amount of taxes to be paid in the future. So an increase in deferred tax liabilities should be subtracted to get the actual amount of cash taxes that were paid. Conversely, a decrease in deferred tax liabilities should be added up.
Tax-deductible nonoperating expenses reduce the amount of cash taxes actually paid. This distortion can be offset by adding up the tax shield.
Tax Shield = Tax-deductible Nonoperating Expenses × Tax Rate
XYZ Company reported financial statements for the last year.
Balance sheet, US $ in thousands
Income statement, US $ in thousands
Some part of the company’s equipment is used under an operating lease agreement, which will be valid for another 3 years. Lease payments are expected to be made at the end of each year and total $3,800,000. The WACC of XYZ Company is 11.63%, and the corporate tax rate is 30%.
Let’s calculate NOPAT using both an operating and a financing approach.
Since XYZ Company disclosed EBIT (operating income) in the income statement, we can use the operating approach to get NOPAT’s final number. To do this, we should make a series of adjustments:
As mentioned above, we have to treat an operating lease similar to a capital lease. An operating lease is a source of off-balance sheet financing, so we should move it back to the balance sheet. For the first step, it is necessary to find the present value of the expected future payment under the operating lease obligation.
|PV =||$3,800,000||+||$3,800,000||+||$3,800,000||= $9,185,303.64|
|(1 + 0.1163)1||(1 + 0.1163)2||(1 + 0.1163)3|
Thus, the implied value of the operating lease as a debt-like obligation is $9,185,303.64. To find the implied interest obligation for an operating lease, the WACC should be applied.
Implied interest obligation = $9,185,303.64 × 11.63% = $1,068,250.81
Finally, let’s sum up all the adjustments and get the final number of net operating profit after taxes of $8,172,250.81.
NOPAT = $8,480,000 + $24,000 - $140,000 + $360,000 - $1,620,000 + $1,068,250.81 = $8,172,250.81
In some cases, accounting standards don’t force companies to disclose operating income (EBIT) in their income statements. In such a situation, the financing approach should be used. We start with net income and adjust it as follows:
NOPAT = $3,780,000 + $24,000 - $140,000 + $360,000 + $1,200,000 + $1,880,000 + $1,068,250.81 = $8,172,250.81
So, as we can see, both the operating and the financing approach resulted in the same final number.
As shown above, NOPAT is a more precise measurement of economic profit than EBIT because it gives the exact amount of operating cash generated, and EBIT is a metric used in financial statements and calculated on an accrual basis. Thus, EBIT less taxes rarely equals economic profit.