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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 10 © 2014 Paul Farris, Neil Bendle, Stu James and Management by the Numbers, Inc.

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P ROFITABILTY M ETRICS 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. MBTN | Management by the Numbers 2

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E XAMPLE B USINESS 3 Example Business MBTN | Management by the Numbers Jamie’s Income Statement 2013$000 Total Revenue100 Cost of Revenue45 Gross Profit55 Selling, General and Admin.20 Depreciation10 Operating Income or Loss25 Interest Expense5 Pre-Tax Income20 Income Taxes6 Net Income14 Jamie runs a small import business and has generated the following income statement for 2013. 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.

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N ET I NCOME Net Income Definition 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 ($) 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? MBTN | Management by the Numbers 4 Jamie’s Income Statement 2013$000 Total Revenue100 Cost of Revenue45 Gross Profit55 Selling, General and Admin.20 Depreciation10 Operating Income or Loss25 Interest Expense5 Pre-Tax Income20 Income Taxes6 Net Income? Answer: Net Income = $100,000 - $86,000 = $14,000

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M EASURES OF P ROFITABILITY Other Measures of Profitability MBTN | Management by the Numbers 5 Jamie’s Income Statement 2013$000 Total Revenue100 Cost of Revenue45 Gross Profit55 Selling, General and Admin.20 Depreciation10 Operating Income or Loss25 Interest Expense5 Pre-Tax Income20 Income Taxes6 Net Income14 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. Now let’s introduce simple ratio analysis using these same measures

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M EASURES OF P ROFITABILITY R ATIOS Measures of Profitability Ratios MBTN | Management by the Numbers 6 Jamie’s Income Statement 2013$000 Total Revenue100 Cost of Revenue45 Gross Profit55 Selling, General and Admin.20 Depreciation10 Operating Income or Loss25 Interest Expense5 Pre-Tax Income20 Income Taxes6 Net Income14 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.

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EBIT 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 ($) + Taxes ($) Question 3 Based on the Income Statement on the right, what was EBIT for Jamie’s business in 2013? MBTN | Management by the Numbers 7 Jamie’s Income Statement 2013$000 Total Revenue100 Cost of Revenue45 Gross Profit55 Selling, General and Admin.20 Depreciation10 Operating Income or Loss25 Interest Expense5 Pre-Tax Income20 Income Taxes6 Net Income14 Answer: EBIT= $14,000 + $6,000 + $5,000 = $25,000

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EBITDA 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 ($) Question 4 Based on the Income Statement on the right, what was EBITDA for Jamie’s business in 2013? MBTN | Management by the Numbers 8 Jamie’s Income Statement 2013$000 Total Revenue100 Cost of Revenue45 Gross Profit55 Selling, General and Admin.20 Depreciation and Amortization10 Operating Income or Loss25 Interest Expense5 Pre-Tax Income20 Income Taxes6 Net Income14 Answer: EBITDA= $14,000 + $6,000 + $5,000 + $10,000 = $35,000

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E FFECTIVE T AX R ATE Effective Tax Rate Definition 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 Question 5 Based on the Income Statement on the right, what was the Effective Tax Rate for Jamie’s business in 2013? MBTN | Management by the Numbers 9 Jamie’s Income Statement 2013$000 Total Revenue100 Cost of Revenue45 Gross Profit55 Selling, General and Admin.20 Depreciation and Amortization10 Operating Income or Loss25 Interest Expense5 Pre-Tax Income20 Income Taxes6 Net Income14 Answer: Effective Tax Rate= $6,000 / $20,000 = 30%

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NOPAT 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) Question 5 Based on the Income Statement on the right, what was NOPAT for Jamie’s business in 2013? MBTN | Management by the Numbers 10 Jamie’s Income Statement 2013$000 Total Revenue100 Cost of Revenue45 Gross Profit55 Selling, General and Admin.20 Depreciation and Amortization10 Operating Income or Loss25 Interest Expense5 Pre-Tax Income20 Income Taxes6 Net Income14 Answer: Tax Rate= $6,000 / $20,000 = 30% NOPAT= $25,000 x (1 -.30) = $17,500

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E ARNINGS P ER S HARE (EPS) Earnings Per Share (EPS) Definition 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? MBTN | Management by the Numbers 11 Jamie’s Income Statement 2013$000 Total Revenue100 Cost of Revenue45 Gross Profit55 Selling, General and Admin.20 Depreciation and Amortization10 Operating Income or Loss25 Interest Expense5 Pre-Tax Income20 Income Taxes6 Net Income14 Answers: Basic EPS= $14,000/10,000 = $1.40 Diluted EPS = $14,000/14,000 = $1.00

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R ETURN ON I NVESTMENT (ROI) Return on Investment (ROI) Definition 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? MBTN | Management by the Numbers 12 Jamie’s Income Statement 2013$000 Total Revenue100 Cost of Revenue45 Gross Profit55 Selling, General and Admin.20 Depreciation and Amortization10 Operating Income or Loss25 Interest Expense5 Pre-Tax Income20 Income Taxes6 Net Income14 Answer: ROI= $14,000 / $80,000 = 17.5%

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R ETURN ON N ET A SSETS (RONA) Return on Net Assets (RONA) Definition 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? MBTN | Management by the Numbers 13 Jamie’s Income Statement 2013$000 Total Revenue100 Cost of Revenue45 Gross Profit55 Selling, General and Admin.20 Depreciation and Amortization10 Operating Income or Loss25 Interest Expense5 Pre-Tax Income20 Income Taxes6 Net Income14 Answer: RONA= $14,000 / $60,000 = 23.3%

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EVA (E CONOMIC V ALUE A DDED ) Economic Profit (EVA) Definition 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? * Economic Value Added -- EVA® is a Stern Stewart & Co. trademark MBTN | Management by the Numbers 14 Jamie’s Income Statement 2013 $000 Total Revenue 100 Cost of Revenue 45 Gross Profit 55 Selling, General and Admin. 20 Depreciation and Amortization 10 Operating Income or Loss 25 Interest Expense 5 Pre-Tax Income 20 Income Taxes 6 Net Income 14 Answer: EVA= $17,500 - $5,000 = $12,500

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F URTHER R EFERENCE 15 Further Reference MBTN | Management by the Numbers 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.

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