Understanding the effective tax rate can be very helpful in analyzing financial statements. Let me show you why! When financial analysts review an income statement, one of the first things they do is calculate top line growth and bottom line growth. Here’s the top line (revenue) for three years for Microsoft. In absolute terms, revenue increased from $97 billion in 2017 on the right to $110 billion in 2018 in the middle to $126 billion in 2019 on the left. The growth rate from 2017 to 2018 is 14%. The growth rate from 2018 to 2019 is 14% as well. Which growth rates do you expect for Net Income? Growing faster than revenue? Growing at the same rate as revenue? Growing, but slower than revenue? Or fluctuating more wildly?

⏱️TIMESTAMPS⏱️
0:00 Top line growth vs bottom line growth
1:45 Provision for income taxes
2:32 Effective tax rate calculation
3:16 Statutory tax rate vs effective tax rate
4:25 Foreign earnings taxed at lower rates
5:50 Effective tax rate analysis

Here’s the bottom line (net income) for the same years. Net income in 2018 declined from net income in 2017 by 35%: from $25 billion to $17 billion. Net income in 2019 increased by 137% compared to 2018: from $17 billion to $39 billion. There are two ways to start analyzing this: working our way down the income statement from revenue through gross margin through operating income, or working our way up the income statement from net income. Let’s see what shows up if we go up the income statement starting from the bottom line.

The lines in the income statement straight above net income are income before income taxes, and provision for income taxes. Income before income taxes minus provision for income taxes equals net income. Income before income taxes grew at 22%, and then 20%, more in line with the revenue growth of 14% per year. If revenue grows at 14% per year, and costs do not grow at that same rate, then 20 to 22% income before tax growth is a reasonable expectation. If income before income taxes is growing at stable rates, while net income fluctuates heavily, then the provision for income taxes is the line item that causes the variability.

Let’s put that provision for income taxes in perspective by calculating the effective tax rate: simply dividing the provision for income taxes by the income before income taxes, for each of the years. In 2017, $4.4 billion divided by $29.9 billion yields an effective tax rate of 14.8%. In 2018, $19.9 billion divided by $36.5 billion yields an effective tax rate of 54.6%. In 2019, $4.4 billion divided by $43.7 billion yields an effective tax rate of 10.2%.

Here’s the list of reconciling items between statutory tax rate and effective tax rate downloaded from the Microsoft annual report. A recurring line item is foreign earnings taxed at lower rates, which lowers the effective tax rate. The vast majority of the foreign, in other words non-US, income before tax is generated in foreign regional operating centers in Ireland, Singapore and Puerto Rico. This income is taxed at rates lower than the US statutory rate, both before and after the US tax law change. The second line item is the one-time impact of the new US tax law, which actually led to significant one-time tax expenses, and therefore a higher effective tax rate than the statutory rate for Microsoft in fiscal year 2018, nearly 38% of income before taxes. Third line item is the realization of tax benefits attributable to previous Phone business losses in fiscal year 2017. Fourth line item is $2.6 billion net income tax benefit (equal to 6% of income before taxes) related to intangible property transfers. The remaining line items are much smaller in size than the first four.

In short: effective tax rate analysis can help explain fluctuations in net income, by providing a reconciliation from the statutory corporate tax rate to the effective tax rate.

Philip de Vroe (The Finance Storyteller) aims to make #accounting, #finance and investing enjoyable and easier to understand. Learn the business and accounting vocabulary to join the conversation with your CEO at your company. Understand how financial statements work in order to make better investing decisions. Philip delivers #financetraining in various formats: YouTube videos, classroom sessions, webinars, and business simulations. Connect with me through Linked In!