This article sought to highlight the tax burden’s role in determining companies’ profit, a critical element for its validity in indicators measuring companies’ profitability and value.
In this article, an attempt was made to bring to the debate on finance a different look at the weight of the tax burden in the determination of the profits ascertained by corporate entities, as well as its subsumption to corporate compliance, due to the relevance and importance in the impact on profitability in their businesses.
When we research data and information about the value of a company, several questions arise, such as: How to invest? Where to invest? Should I buy shares of which company? What is the value of a company? Which value of a company should be considered in the acquisition or merger of companies?
Investors, financial analysts, and specialists in acquisitions and mergers use many methods of valuing organizations to make an investment decision.
Among the main methods of company valuation, the most used by the market are the following:
- Valuation by Equity Value;
- Valuation by Market Value;
- Multiple Valuation;
- Valuation by Discounted Cash Flow.
Each has its particularities and importance for each phase of the company, of the negotiation or the intended transaction.
However, in addition to the technical criteria mentioned above, the geopolitical and economic scenarios, which directly affect the cost of capital of companies (Damodaran, 2022), or sustainability policies through the so-called “ESG,” which directly affect the value of a given company, must be considered.
But are these methods sufficient to ascertain a company’s profitability and value?
We see that all methods are based on existing data, published by the corporate entities, and contained in the financial statements (sources: company reports and statements, statements of income, balance sheets, and trial balance).
Therefore, they evaluate profitability from static data, a snapshot on a base date. This fact is corroborated by the note in the material published by FIA (2021), as follows: “Financial indicators are quantitative measures that disclose the financial situation of a company based on its accounting results. They are excellent tools that help both the manager in his decision-making and the investor looking for the best risk x return ratio for their capital.
The indicators are based on historical data, that is, past performance.” (emphasis ours)
Thus, another question arises: are these data correctly represented and validated by technical criteria – scientific or even empirical?
According to Assaf Neto (2019), “Valuation and value creation themes started to have greater importance in Brazil mainly after the period of privatization of companies and economic opening, which occurred from the 1980s. Globalization has demonstrated that companies must have the capacity to produce economic value to attract investment and justify their economic existence. This reality brought new parameters for the valuation of companies in Brazil, making the calculated value more reliable and closer to the investors.”
Thus, this article seeks to discuss a new method to be considered: a new look at the corporate tax burden, which directly affects profit, profitability, and the distribution of profits and dividends.
For this purpose, the proposed financial trilogy considers the tax burden, corporate compliance, and profits as methods of validating the latter element and all other indicators arising therefrom.
At this moment, according to our evaluation, given the relevance, we identify the first criticism of the models under discussion, because the tax burden directly affects the indicators of EBITDA Margin and Net Margin, used as indicators for measuring the profitability of the company. Just check the composition of these indicators, which in the first does not consider the taxes paid by the entities, as well as in the second, which consider the net income, less taxes. However, the latter only considers the corporate taxes – IRPJ (corporate income tax) and CSLL (social contribution on net profit), since the others were deducted to determine the gross profit, in the DRE (Statement of Income for the Fiscal Year)
- EBITDA Margin = EBITDA/revenue *100
- Net Margin = Net Profit/Revenue *100
Besides this impact, the relevance and importance in determining the profit are evident when we analyze the profitability indicators of the companies, such as ROE, ROIC, and ROA.
But what are these alphabet soups? And what is their importance and connection with the financial trilogy?
For the purposes and understanding of this article, we will explain each of these indicators, using the simplified concepts of Bozza, Stéfano (2020), and the material published in the FIA blog, see here.
ROE, ROIC, and ROA: what does each fundamentalist multiple mean?
First of all, you should understand that the three acronyms represent a profitability analysis. This means, in other words, that we have three different views to assess the return provided by an investment.
Let’s start by understanding what these acronyms stand for in order to understand how to use them to our advantage when valuing companies.
How to analyze ROE and ROA?
These indicators can be calculated with the following formulas:
- ROE = Net Profit / Shareholders’ Equity.
- ROIC = NOPAT / Capital Invested.
- ROA = Net Profit / Total Assets.
What is ROE for?
ROE is an indicator that measures a company’s ability to generate value for the business and investors based on the company’s resources.
This metric can be used by company officers, investment managers, or investors in general.
ROE is the best-known of these profitability metrics. It stands for Return on Equity.
Shareholders’ Equity is the name given to the company’s value as the initial investment of its members added to its shareholders, as well as earnings and losses from its results.
ROE, therefore, offers the possibility to assess whether a company can generate value based on the use of its own resources. This indicator can be calculated with the following formula:
ROE = Net Profit / Shareholders’ Equity
What is a good ROE?
Currently, the main managers in the market consider a good ROE to be above 15% per year. However, this value is not exhaustive, serving only as an analysis parameter. In addition, it is important to emphasize that, for comparison purposes, companies in the same segment are always used.
ROIC: Return on Invested Capital
Our second metric is ROIC (Return on Invested Capital), which represents the return on invested capital. That is, this indicator will tell us how efficiently a company generates profit with the cash it has available for investment.
Here, unlike ROE, we can also contemplate third-party capital (such as loans, financing, and debt securities). For example, if there is an issue of debentures to invest in a new project, these resources should be contemplated in the metric.
To find the ROIC, the calculation is made based on the NOPAT (Net Operating Profit After Taxes), which is the Operating Profit generated by the Company after taxes. Thus, the formula used is as follows:
ROIC = NOPAT / Invested Capital
It is also worth pointing out that ROIC, although it has a similar acronym, is different from ROI. This other indicator evaluates the return on an isolated investment – something that, when we think about the analysis of a company for long-term investment, has less relevance.
What is NOPAT in accounting?
NOPAT is an acronym for Net Operating Profit After Taxes. This indicator measures a company’s capacity to generate revenue, and its performance, in order to determine whether it is profitable.
How is NOPAT calculated? NOPAT = EBITDA X (1 – T)
In this case, the Statement of Income is very simplified, and the Operating Income equals the EBITDA. To calculate the NOPAT, we multiply the value of R$ 2,700.00 by one minus the income tax and social contribution on net profit rate (in this example, 34%). Then, NOPAT = R$ 2,700.00 * (1-34%) = R$ 1,782.00.
ROA: Return on Assets
ROA (Return on Assets), on the other hand, represents the return obtained by the company with its investments in relation to its assets, which is the total that the company owns, including assets and rights.
This metric has the distinction of blending the sources of capital we saw earlier. That is, you can have assets obtained by the capital of members and shareholders, as well as the capital of suppliers and financial institutions, such as banks.
The calculation is quite simple and indicates the capacity to value a company’s assets. See below the formula used to find the ROA of a business:
ROA = Net Profit / Total Assets
How to analyze ROE, ROIC, and ROA indicators in order to invest?
Now you know the main profitability indicators of a Fundamentalist Analysis, as well as their respective calculation formulas.
Since all the indicators deal with the capacity to generate profit, naturally, the results can be seen from the standpoint of “the higher, the better.” However, this is a very superficial assessment.
And here we see the connection between the objectives outlined in this article with the metrics presented above and the financial trilogy. Everything is affected by and based on the profit earned by corporate entities.
Therefore, tax burden, corporate compliance, and profit are fundamental elements for validity in determining the profit, whether gross or net, and its use by the indicators EBITDA Margin, Net Margin, ROE, ROIC, and ROA, for investment decisions.
For those who want to deepen their studies on the distribution of profits and dividends, they can read “O ENIGMA DOS DIVIDENDOS E O RISCO SISTEMÁTICO”, by Bernardo, Heloísa Pinna, Ikeda, Ricardo Hirata, in Revista Universo Contábil. ISSN 1809- 3337, Blumenau v. 9, n.1, p. 104-120, Jan/Mar. www.furb.br/universocontabil
Thus, managing many taxes, keeping up with the changes in the legislation in several areas, defining the correct incidence of taxes according to the business operations, and being in compliance within this complex universe are the difficulties faced on a daily basis by managers, executives, and professionals in the tax, financial, and strategy areas of the companies.
One of the fundamental elements to analyze the tax burden – besides tax compliance programs is Tax Planning, as it tangents the tax evasion line. The analysis of this mechanism must consider and avoid the practice of abusive planning, together with the concepts of tax evasion and tax avoidance. These elements are part of the proper analysis of the so-called lawful and legal Tax Planning.
Therefore, for Costa and Amorim Júnior (2020), “tax planning is a strategic way to increase competitiveness, profitability and, often, business viability, being, ultimately, a way to obtain resources internally. Thus, the reduction of the tax burden arising from these instruments can be a potential driver for the realization of the business.”
According to Minnick and Noga (2010), “Examining the link between governance and tax planning (versus other aspects of a company’s operating decisions) is interesting for two reasons. First, tax planning can be complex and opaque and can possibly allow for managerial opportunism. Therefore, understanding the role that governance plays in tax management becomes more important. Second, tax planning involves significant uncertainty, and may not immediately benefit a company’s performance; instead, it serves as a long-term investment. By understanding how governance is related to tax management, we g better understand how governance works in the long and short term.”
Also, according to Minnick and Noga (2010), “Officers and CEOs play a key role in choosing a tax management strategy; they are responsible for resource allocation, performance, and increasing shareholder wealth. Officers have a finite number of choices regarding how to allocate resources and improve performance. A board interested in top-line performance improvement focuses primarily on sales growth through advertising or physical (capital) expansion and will divert resources to these goals. Alternatively, they may also choose to focus on final performance. Effective tax management is an important driver of financial performance; when the board invests funds in value-maximizing activities such as tax planning, the result is: lower taxes and improved bottom-line performance.”
This article sought to highlight the role of the tax burden, corroborated by the subsumption of legal rules and the principles of corporate governance, in determining corporate profits, a fundamental element for the validity of its use in the measurement indicators of corporate profitability and value.
We could not fail to add one more discussion for reflection: should Tax Management not be part of the companies’ strategies, under the supervision of the companies’ controlling and executive bodies?
The strategic management of organizations is one of the most instigating fields in administration and finance, because it provides the need for applying a long-term vision and business sustainability. Moreover, with increased competition in all sectors, the globalization process, and the endless availability of information, the strategic thinking process must be flowing permanently in organizations.
Which organizational processes should be considered in how entrepreneurs, executives, and managers manage a business, considering the dynamism of the current social and economic context?
The research conducted by the company Deloitte Brazil consolidates and brings for debate and analysis some questions about the future of the tax function:
Costa, Fábio Moraes da e Amorim Júnior, Radjalma Lucena: Revista Evidenciação Contábil & Finanças, v. 8, n. 3, p. 5-22, September-December, 2020. 18 pages.
Kristina Minnick, Tracy Noga: Do corporate governance characteristics influence tax management? In Journal of Corporate Finance, Volume 16, Issue 5, 2010, Pages 703-718, ISSN 0929-1199, https://doi.org/10.1016/j.jcorpfin.2010.08.005.
Damodaran, 2022 – NEOFEED: revista semanal. São Paulo: Ed. de 12/04/2022)
Bernardo, Heloísa Pinna, Ikeda, Ricardo Hirata. O ENIGMA DOS DIVIDENDOS E O RISCO SISTEMÁTICO. Revista Universo Contábil, ISSN 1809-3337, Blumenau, v. 9, n. 1, p. 104-120, Jan./Mar., 2013. Dói: 10.4270/ruc.2013106. www.furb.br/universocontabil
Bozza, Alexandre. With a degree in Business Administration from PUC-SP, he worked in companies in the financial segment (Itaú BBA) and retail (BRMALSS) until 2016, when he began his journey of producing content for the internet with a focus on finance. Article published on 11/24/2020, in the blog of the website
Indicadores financeiros: O que são, os principais e como analisar. https://fia.com.br/blog/indicadores- financeiros/
Deloitte: Research – Tax Transformation Trends: Operations Focus: Enhancing Strategic Value in a Transforming Environment, May 2021, available at Tax Transformation Trends Research | Deloitte Brazil