Taxes incorporate operating, non-operating and financing items. One wants to assess the core operations of a business, free of any financing effects, in order to estimate net operating profits after tax (NOPAT), and so, one must break off operating taxes, from taxes on non-operating accounts, and other non-operating taxes. This gives us the taxes the firm would pay if it only engaged in its core activities and was wholly equity financed.
I start with reported provision for income taxes or income tax expense, and then subtract the change in the deferred tax account in order to convert taxes from an accrual to cash basis. When a company pays less in cash taxes than it reports in book taxes, it earns a deferred tax liability, a source of cash, and when it pays more in cash taxes than it reports in book taxes, it earns a deferred tax asset, a use of cash. The deferred tax account can be found on the balance sheet, but when they are not separately detailed, the relevant information can be found in the cash flow statement under the “Cash flows from the operating activities” section, as part of the adjustments to reconcile net income to net cash provided by operating activities; or, it can be found in the footnotes.
Then, I unlever cash taxes by adding back the debt tax shield from from net interest expense and operating, variable and not-yet commenced leases. This is done by multiplying the debt expense by the marginal tax rate, and adding the sum to cash taxes. Finally, I reverse the impact other non-operating accounts. Where there is information on tax benefit of non-operating items, with pre and post-tax values given, I reverse the impact of that as well. This process gives us an estimate of cash operating taxes.
This whole process can be seen in the example below in which I calculate Diamond Hill’s cash operating taxes.