Term · Profitability & Growth
Effective Tax Rate
In briefThe effective tax rate measures income tax expense relative to pre-tax profit and shows the effective tax burden. It deviates from the nominal rate due to loss carryforwards, deferred taxes, or special effects. A very low rate can flatter net profit only temporarily.
Definition
The effective tax rate relates the reported income tax expense to pre-tax profit. It shows a company's effective tax burden, which can deviate from the nominal tax rate. Causes include loss carryforwards, tax-free income, or deferred taxes.
How it is calculated
Formula. Effective tax rate = Income tax expense ÷ Pre-tax profit × 100 %
Why it matters for small caps
At small caps, an unusually low tax rate from loss carryforwards can temporarily inflate net profit. When this effect falls away, profit declines without the operating business deteriorating.
Common misreadings
- A low tax rate is read as a lasting strength, even though it is often due to temporary effects such as loss carryforwards.
In the process
Frequently asked
Why does the effective tax rate deviate from the nominal tax rate?
Due to loss carryforwards, tax-free income, non-deductible expenses, or effects from deferred taxes, the effective rate can deviate significantly.
What does a very low tax rate mean?
Often the company uses loss carryforwards. Once these are used up, the rate normalizes and net profit declines accordingly.
Why is a normalized view useful?
To assess sustainable earning power, one should calculate profit using a normalized tax rate and exclude one-off effects.
Related terms
Education only, not investment advice. Ranges and thresholds are didactic orientation values, not an official standard.