Financial Metrics I: Measures of Profitability

Transcription

1 Financial Metrics I: Measures of Profitability This module covers the definitions of common financial measures used in business and marketing including Net Income, Gross Profit, Operating Profit, Pre-tax Profit, EBIT, EBITDA, Effective Tax Rate, NOPAT, Return on Sales (ROS), EPS, ROI, RONA, and EVA. Authors: Paul Farris, Neil Bendle, and Stu James Marketing Metrics Reference: Chapter Paul Farris, Neil Bendle, Stu James and Management by the Numbers, Inc.

2 Profitability Metrics Profitability metrics covered in this tutorial are grouped into two categories: Measures that are found on the income statement or ratios that use values directly found on the income statement. Net Income (Net Profit), Gross Profit, Operating Profit, Pre-Tax Profit and ratios of these values relative to total revenue, including ROS. Measures that require further calculations using values in the income statement and elsewhere that provide additional insight into financial condition of a firm. EBIT, EBITDA, NOPAT, EPS, ROI, RONA, EVA We ll use a very simple business, shown on the next slide, to illustrate these various measures. PROFITABILTY METRICS 2

3 Example Business Jamie runs a small import business and has generated the following income statement for EXAMPLE BUSINESS Depreciation 10 We also know that Jamie s business has $10,000 of cash and $50,000 of other assets. Based on this information, let s explore some of the commonly used financial measures Jamie might use to measure the profitability of the business. 3

4 Definition Net Income Net Income measures the profitability of a business after accounting for all costs (including interest and taxes). Often called Net Profit. Net Income ($) = Sales Revenue ($) Total Costs ($) NET INCOME Question 1 In 2013, Jamie s business generated $100,000 of total sales revenue and $86,000 of total costs. What was the net income for the company in 2013? Net Income = $100,000 - $86,000 = $14,000 Depreciation 10 Net Income? 4

5 Other Measures of Profitability While Net Income is the bottom line of the business, there are three other measures of profitability directly reported on the income statement that indicate profitability based on what expenses are included in the calculation. Gross Income or Profit Operating Income or Profit Pre-Tax Income or Profit Each measure provides a different insight into the financial performance of a business and managerial decision-making. Depreciation 10 Now let s introduce simple ratio analysis using these same measures MEASURES OF PROFITABILITY 5

6 Measures of Profitability Ratios These four measures of profitability are often also provided as a ratio relative to sales. Thus, Net Profit Margin = Net Income / Total Revenue. Another name for Net Profit Margin is Return on Sales. Question 2: Calculate the four measures of profitability as a ratio relative to sales. Answers: Gr. Profit Margin = $55 / $100 = 55% Oper. Profit Margin = $25 / $100 = 25% Pre-Tax Margin = $20 / $100 = 20% Net Profit Margin = $14 / $100 = 14% Insight Ratios allow us to compare performance across different size businesses by normalizing performance. In this example, by measuring profitability against sales. Depreciation 10 MEASURES OF PROFITABILITY RATIOS 6

7 EBIT Earnings Before Interest and Taxes Definition EBIT is a measure of earnings that removes the effects of the different capital structures and tax rates used by different companies and was a precursor to EBITDA. EBIT ($) = Net Income ($) + Interest Payments ($) + Taxes ($) EBIT Question 3 Based on the Income Statement on the right, what was EBIT for Jamie s business in 2013? Depreciation 10 EBIT = $14,000 + $6,000 + $5,000 = $25,000 7

8 EBITDA Earnings Before Interest, Taxes, Depreciation, Amortization Definition EBITDA is a rough measure of operating cash flow, which reduces the effect of accounting, financing, and tax polices on reported profits. EBITDA ($) = Net Income ($) + Interest Payments ($) + Taxes ($) + Depreciation and Amortization Charges ($) EBITDA Question 4 Based on the Income Statement on the right, what was EBITDA for Jamie s business in 2013? Depreciation and Amortization 10 EBITDA = $14,000 + $6,000 + $5,000 + $10,000 = $35,000 8

9 Definition Effective Tax Rate Effective Tax Rate measures the average tax rate paid by a corporation during a period of operations. Effective Tax Rate (%) = Income Tax Expense / Pre-Tax Income EFFECTIVE TAX RATE Question 5 Based on the Income Statement on the right, what was the Effective Tax Rate for Jamie s business in 2013? Depreciation and Amortization 10 Effective Tax Rate = $6,000 / $20,000 = 30% 9

10 NOPAT Net Operating Profit after Taxes Definition NOPAT is an operating performance measure after taking account of taxation but before financing cost (i.e. interest is excluded). Compared to EBIT, NOPAT provides a better performance measure of cash yield. NOPAT ($) = EBIT x (1 Effective Tax Rate) NOPAT Question 5 Based on the Income Statement on the right, what was NOPAT for Jamie s business in 2013? Depreciation and Amortization 10 Tax Rate = $6,000 / $20,000 = 30% NOPAT = $25,000 x (1 -.30) = $17,500 10

11 Definition Earnings Per Share (EPS) Earnings per Share measures profitability on the basis of shares of stock. This can either be basic (current shares issued) or diluted (includes all options, warrants, and convertible shares). EPS = Net Income ($) / Total Shares (basic or diluted) Question 6 If Jamie s company has 10,000 shares issued and with 4,000 additional options if certain targets are met, what are basic and diluted EPS for 2013? Depreciation and Amortization 10 EARNINGS PER SHARE (EPS) Answers: Basic EPS = $14,000/10,000 = $1.40 Diluted EPS = $14,000/14,000 = $

12 Definition Return on Investment (ROI) Return on Investment is one way of considering profits in relation to capital invested. Return on Investment (%) = Net Income ($) / Investment ($) Question 7 If Jamie s business started with $80,000 of capital, what is the company s ROI for 2013? Depreciation and Amortization 10 RETURN ON INVESTMENT (ROI) ROI = $14,000 / $80,000 = 17.5% 12

13 Definition Return on Net Assets (RONA) Return on Net Assets is another way to consider profits in relation to capital invested, where net assets includes both working capital and fixed assets. Return on Net Assets (%) = Net Income ($) / Net Assets ($) Question 8 Recall that Jamie s business currently has $10,000 of cash and $50,000 of other assets. What is the company s RONA for 2013? Depreciation and Amortization 10 RETURN ON NET ASSETS (RONA) RONA = $14,000 / $60,000 = 23.3% 13

14 Definition Economic Profit (EVA) Unlike percentage measures of return (e.g., ROS or ROI), Economic profit or EVA* is a dollar metric. It reflects not only the rate of profitability, but also the size of the business (sales and assets). EVA = NOPAT Cost of Capital (or = NOPAT - Capital * WACC) Question 9 If the cost of capital for Jamie s business is $5,000, what is the EVA of Jamie s business? EVA (ECONOMIC VALUE ADDED) Depreciation and Amortization 10 EVA = $17,500 - $5,000 = $12,500 *Economic Value Added -- EVA is a Stern Stewart & Co. trademark 14

15 Further Reference Marketing Metrics by Farris, Bendle, Pfeifer and Reibstein, 2 nd edition, chapter 10. MBTN Income Statement module which introduces the components of the income statement. - And - MBTN NPV II Module which describes measures of profitability appropriate for projects and investments. FURTHER REFERENCE 15