Q 513.  PAT (Profit After Tax), Free Cash Flow and ROI (Return on Investment) are the 3 more common metrics to check the financial health of the organization. If Free Cash Flow is the top priority for the business, will this mean that the Lean Six Sigma projects will need to be different from a scenario where PAT is the top priority? Explain with examples.

 

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What Is Profit After Tax (PAT)?

 

According to the Indian business laws each business unit is required to pay annual income taxes. Profit after tax is defined as business earning after the income taxes are deducted. It is consistently regarded as the company's total profit and the greatest strategy to provide a return. Operating income and other types of revenue, such as interest income, are included in PAT.

 

Investors typically keep a close eye on a company's PAT in order to track changes over time. Thus, it serves as a valuation indicator that also influences a company's stock price. In other words, if you're wondering "what is profit after tax," it's the last sum that a company keeps after paying all of its taxes and debts and divides among its shareholders as retained earnings.

 

How Profit After Tax (PAT) is important for a Company?

 

The amount that a company and its shareholders can keep after taxes is known as profit after tax. In this regard, the following characteristics of this topic can help you comprehend it better.

 

·        PAT is a crucial financial metric that tracks the growth or decline of a company's retained earnings.

·        People frequently use it for margin research, especially when comparing businesses within an industry. It reflects an organization's capacity for transforming sales into profits.

·        By examining a company's PAT, investors can assess its ability to generate profits.

·        Businesses can utilise their PAT to determine whether or not they need to control their expenses.

 

What is the Formula to Calculate Profit After Tax (PAT)?

 

 

Profit Before Tax (PBT): This figure is arrived at by adding up all costs, including operating and non-operating. After then, it is taken out of the total revenue (operating and non-operating revenue).

 

Tax rate: The taxation is based on PBT, and a company's tax rate is based on where it is located.

 

You can better comprehend the Net Profit After Tax formula by using the following example:

 

IABC Pvt Ltd generates $50,000 in sales per year. Its operating costs are 15,000 and its non-operating costs are 5,000, respectively. The current tax rate is around 30%.

 

Particulars	Amount
Annual revenue	₹ 50,000
Operating expenses	₹ 15,000
Non-operating	₹ 5,000
Tax rate	30%
Profit Before Tax (₹ 50,000 - ₹ (15,000 + 5,000)	₹ 30,000
Taxable amount (30% of ₹ 30,000)	₹ 9,000
Profit After Tax (₹ 30,000 - ₹ 9,000)	₹ 21,000

 

Thus, PAT of ABC Pvt Ltd is ₹ 21,000.

 

What Is the Significance of Profit After Tax (PAT)?

 

For the purpose of evaluating the development and capabilities of an organisation, the idea of Net Profit After Tax is important. Financial data showing a company's performance in terms of its financial developments is provided to the employers' internal and external management. The tax burden is already reduced by one factor, so business owners can consider how to increase their company's take-home earnings.

 

A company's net income will rise if it operates in a sector that offers significant tax advantages. However, a company's net income will inevitably fall if the industry experiences unfavourable tax benefits. Regardless of the current tax legislation, business owners can compare their activities to those of other companies after computing the PAT.

 

Additionally, Profit After Tax aids investors in the analysis of their investment choices. They can get a complete picture of a company's financial competency by calculating and looking at its PAT. The investor will have to determine whether or not to continue investing in it if this starts to decline.

 

What Are the Advantages of Profit After Tax (PAT) Measures?

 

Profit After Tax has several benefits that you should consider implementing in your business now that you are aware of its functions and goals.

 

·        The increased stock price momentum helps companies attract investors.

·        PAT increases liquidity in companies, thereby providing funds for emergencies and assisting a company to survive without taking loans.

·        PAT increases stockholder equity and stock value by adding retained earnings to the corporate balance sheet.

·        Investors may become interested in providing finance for a firm's expansion as they learn more about the retained earnings of the company.

 

What Are the Disadvantages of Profit After Tax (PAT) Measures?

 

Although most organizations and their future growth can benefit from Profit After Tax, one should also consider its drawbacks in this context.

 

Shareholders prefer bigger dividend payments over reinvested profits in order to boost stock value, and interest rates are more advantageous for businesses borrowing money than relying solely on the growth rates of an existing profit.

As you can see, Profit After Tax is a crucial component for evaluating the financial competence and profitability of businesses. All taxable amounts must be subtracted from the calculation once they have been paid. Maintaining this sum enables you to analyze your company's retained earnings for the benefit of the shareholders.

 

Why do profits decrease after-tax?

 

The after-tax profit margin may alter if net income growth in your business is outpacing sales growth.

 

Is profit after tax in a company the same as net profit?

 

After all taxes have been paid, your company's profit is described using net income after taxes (NIAT). Contrarily, net income subtracts a number of elements from taxes, such as cost of goods sold, depreciation and amortization, costs, interest, etc. for a given accounting period.

 

Free Cash Flow

 

A company's free cash flow (FCF) is the money it has left over after paying for its operating expenses and capital asset maintenance. Free cash flow, then, is the money that remains after a business pays its operating expenses (OpEx) and capital expenditures (Capex).

 

FCF is the money that is left over after paying for expenses like payroll, rent, and taxes and can be used anyway the company sees fit. The management of a company's cash flow will be aided by knowing how to compute and analyze free cash flow. Investors will be able to make wiser investment choices with the help of FCF computation, which will also give them insight into a company's financials.

 

Free cash flow is a crucial metric since it reveals how well a business generates cash. Using free cash flow, investors can determine whether a company has enough cash on hand to pay dividends or repurchase shares. Additionally, a company is better positioned to pay down debt and pursue possibilities that can improve its business the more free cash flow it generates, making it a desirable investment for investors.

 

How to Calculate Free Cash Flow (FCF)

 

Amortization and Depreciation

 

Find the income statement, balance sheet, and cash flow statement to do a different method of free cash flow calculation. Depreciation and amortisation charges should be added back to net income. Subtract current liabilities from current assets in order to account for changes in working capital. After that, deduct capital expenditures (or investments in machinery and equipment):

 

Net Income + Depreciation/Amortization- Change in Working Capital - Capital Expenditure

= Free Cash Flow

 

It might seem strange to include depreciation and amortization as they cover capital expenditures. Free cash flow is intended to assess money being spent right now, not transactions that transpired in the past, which is why the adjustment was made. This makes FCF a great tool for spotting expanding businesses with significant upfront investments that may reduce earnings today but could eventually pay off.

 

Benefits of Free Cash Flow

 

Free cash flow can offer a great deal of information about a company's financial situation. Understanding free cash flow's composition can give investors a lot of relevant information because it includes a number of elements in the financial statement.

 

Undoubtedly, the better, the larger the free cash flow. A diminishing free cash flow, however, is not always a bad thing if it results from new investments in the business that will position it to reap greater returns in the future, as we have previously seen from our Macy's example.

 

In addition, cash flow from operations takes asset and liability growth and decline into account, providing a richer knowledge of free cash flow. For instance, if accounts payable kept dropping, it would mean that a business was paying its suppliers more quickly. A corporation would be getting payments from its clients faster if its accounts receivable were falling.

 

Now, if accounts payable were declining because suppliers wanted their money sooner but accounts receivable were rising because customers weren't paying promptly, this could lead to decreased free cash flow because money isn't coming in quickly enough to cover the money going out, which could cause issues for the business in the future.

 

The overall advantages of a strong free cash flow, however, imply that a business can pay off debt, support expansion, distribute profits to shareholders as dividends, and have promising future prospects.

 

Limitations of Free Cash Flow

 

The fact that capital expenditures can fluctuate greatly from year to year and across different businesses is a disadvantage of adopting the free cash flow method. Because of this, it's essential to evaluate FCF throughout a number of time periods and in relation to the company's industry.

 

It's crucial to remember that an abnormally high FCF could be a sign that a firm is not appropriately investing in its operations, such as by modernizing its plant and equipment. Negative FCF, on the other hand, can indicate that a business is heavily spending in growing its market share, which would probably result in future growth rather than necessarily being in financial problems.

 

Investors in value frequently seek out businesses with high or improving cash flows but discounted stock prices. Rising cash flow is frequently regarded as a sign that further expansion is likely.

 

Return on Investment (ROI)

ROI gauges the likelihood of profiting from investments.

 

Return on investment, sometimes known as ROI, is a simple way to gauge profitability. After deducting its expenses, how much money did an investment make (or lose)?

 

Many business and investment choices are based on return on investment (ROI). It can be used to estimate the potential return on a new investment, compare the potential returns of various investment options, or determine the actual returns on an investment.

 

The ROI formula, for instance, can be used to calculate the expenses and prospective returns of a business owner's decision to expand into a new product line. An ROI assessment can assist a business owner in deciding whether a new initiative is likely to be profitable. The ROI formula is a simple indicator of actual or anticipated stock performance for investors who are assessing past or future stock acquisitions.

 

How Is Return on Investment (ROI) Used?

 

An easy way to determine the return on an investment is to use ROI. It can be used to assess the prospective profit or loss of an investment that you are thinking about making as well as to estimate the profit or loss on an existing investment.

 

Remember that ROI ignores a crucial element: the time it took to generate that profit (or make that loss). A stock that returns 10% in a year is obviously better than a stock that returns 10% in four years.

 

Due of this, the annualised return on investment formula may be preferable than the standard return on investment formula. Both are displayed above.

 

How to Calculate Return on Investment (ROI)

 

 

Limitations of ROI

 

1. Because your firm's cash flow is not directly reflected in your ROI, it may not always be possible to fully or accurately assess the financial health of your company using ROI alone.

 

2. You must have a clear knowledge of your anticipated future business expenses in order to compute a ROI accurately.

 

3. ROI only evaluates a project's financial success.

 

The most important thing to remember is that a ROI only provides certain data, thus it may not always be representative of the whole business. Although it is a useful calculation, the information it offers is somewhat constrained.

 

Benefits of ROI

 

1. ROIs enable business leaders to monitor and evaluate both short- and long-term projects.

2. ROI enables you to assess the financial performance of your company.

 

Key takeaway: ROI calculations can aid in financial analysis and the formulation of sound company decisions.

 

Conclusion: The profitability of an investment can be measured simply and intuitively with return on investment (ROI). This metric has some restrictions, including as the fact that it does not account for the holding term of an investment and is not risk-adjusted. Despite these drawbacks, ROI is a crucial metric that business analysts use to assess and rate potential investment options.

 

ROI calculations are helpful because they enable you to evaluate the development of your company. Despite being estimates, they have the potential to influence and enhance the choices you make for your organization.

 

Profit after Tax, Return on Investment and Free cash flow all three are financial measure of a company. Any business performance are measure based on this performance. All three financial measure are depends on below three Operational Measure

·       Throughput ( Sales – Total Variable cost)

·       Investment or Inventory (I)

·       Operation Expense (OE)( Any monthly expense)

Profit After Tax: Profit – Tax; which is: Sales – (TVC+Tax+OE) 

Cash Flow: Sales – TVC +∆I

Based on the formula of PAT & Cash flow, Increase in throughput can improve both PAT and Cash flow for a company. But this can’t true on all cases. Some projects on through put focus on TVC while some other focus on sales. Another big trigger for cash flow is the delta on Investment. 

Eg. Broker firm cash flow for do new trade is based on settlement on their broker fee to book more trades. So to improve the cash flow their project will be focused on the collection or Billing process to bring the brokerage fee back to Pnl. In this cases project on improve their sales would make not help company sustain in the market.

Same applicable to any small store where profit is depended on the regular cash flow.

PAT:

The amount that is left over after a company has paid all of its operating and non-operating expenses, other liabilities, and taxes is referred to as profit after tax. This profit is what the company keeps as retained earnings in reserves or distributes to its shareholders as dividends.

 

Features of PAT

§  Numerous other names were also used for it, including Net Operating Profit After Tax (NOPAT) and just Net Profit After Tax.

 

§  Profit After Tax is frequently a useful number when calculating ratios that assess the profitability and effectiveness of the business.

 

§  When a company is publicly traded, Profit After Tax margin (PAT) is used to illustrate how any change in value will affect the stock price.

 

§  Profit After Tax is calculated on a per-share basis if the company is publicly traded and is shown on the income statement of the company.

 

§  PAT values that are high indicate high efficacy, and vice versa.

 

§  The dividends paid to equity shareholders are directly correlated to PAT; the higher the profit after tax, the better the dividends.

 

 

Organizations in practically every sector can gain competitive advantages by implementing the Lean Six Sigma principles to improve financial health of the organization.

 

Lean six sigma will help PAT in the following way

 

a) Error Minimization
Lean Six Sigma enables more concentrated and effective operations in divisions not solely dedicated to manufacturing. According to one case study on billing reconciliation, customer accounts were charged less than what was owed on average 60% of the time due to billing errors. However, the organisation was able to almost completely resolve this issue after implementing LSS.

 

b) Identification of Problem
LSS has the advantage of using quantitative techniques to pinpoint key impact points (KPI). LSS can be used to covertly and effectively address efficiency issues within these KPIs once they have been identified.

The process map is a crucial LSS tool for locating KPIs and any problems they may have. Professionals can identify problems with current procedures and use their findings to improve them or eliminate processes that aren't adding value by defining the boundaries and requirements of the current process.

 

c)Continual Development
Since Lean Six Sigma is intended to be a continuous improvement system, training in LSS is still beneficial years after it was first implemented. Organizations can use the DMADV (Define, Measure, Analyze, Design, Verify) process to create new workflows and processes as well as enhance existing ones by putting it into practise.

Companies like Capital One have discovered that implementing lean six sigma in banking produces results that go far beyond their day-to-day work, despite the initial application of the methodology frequently focusing directly on specific product and process improvements.

 

 

Amongst the published answers M Vijayakumar Elangovan's answer has been selected as the best answer as he has captured the essence of the three financial metrics in terms of its components.

Profit After Tax or Earning after tax is measures of Company's Net profitability which is calculated by subtracting all expenses and taxes from the revenues the business has earned.

 

Example- Sumit corporation reports $1 million of sales in the most recent quarter along with $1,00,000 of before tax profit. The company is subjected to a 21% income tax rate so its reported profit after tax is $ 79,000.

 

Free cash flow is the cash a company generates after taking into consideration cash outflow that supports its operation and maintain its capital assets. This is cash left over after a company pays for its operating expenses and capital expenditure.

 

Example- Befree company has a capital expenditure of $ 20000 and operating cash flow of $ 110000. so net free cash flow will be subtracting Capital expenditure from operating cash flow so Free cash flow will be $ 90000.

 

Return on Investment-  ROI is a popular profitability metric used to evaluate how well an investment has been performed. To calculate ROI, the benefit (or return) of an investment is divided by the cost of an investment. The result is expressed as a percentage or a ratio.

 

Example- a investor invest $ 5000 into amazon stock into 2019 and sold these shares a total of $ 5800 in 2023. The ROI for this investment would be 800/5000 = 16%

 

Conclusion- PAT, Free cash flow and ROI are unique in their areas and provide unique pictures. PAT provides details net profitability whereas ROI Provides investment performed. Free cash flow provides available cash which can be utilize after deduction of all obligation so project should be priorities as per objective of organizations between these three.