Interest and Taxes

Interest is the cost a business pays on borrowed funds, such as loans or bonds. This amount is deducted from operating profit to calculate profit before tax.

Taxes are calculated based on applicable accounting standards and deducted from profit before tax to arrive at net profit.

Consider Prim Corporation, a furniture manufacturer and dealer.

It has an operating income of five million dollars and pays one million dollars in interest on its bank loan.

After subtracting the interest expense, Prim Corporation's profit before tax is four million dollars.

With a corporate tax rate of twenty-one percent, the corporation incurs eight hundred forty thousand dollars in taxes.

The resulting net income, or earnings after taxes, is three million one hundred sixty thousand dollars. This net income represents the earnings available to the business owners or shareholders.

It is important to understand the effect of interest and taxes on profitability, as even if Prim Corporation generates high revenues, a high interest or tax burden can drastically reduce its net profit.