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Marketing & Finance This module covers the definitions of common financial measures used in business and marketing including net profit, EBIT, EBITDA, NOPAT, return on sales (ROS), ROI, RONA, EVA, Payback, discounted cash flow and NPV, internal rate of return (IRR), and weighted average cost of capital (WACC). Author: Paul Farris Marketing Metrics Reference: Chapter 10 © 2011 Paul Farris and Management by the Numbers, Inc. The financial metrics covered in this tutorial are focused in two general areas: Measures typically used at the corporate level that provide insight into the overall financial condition of a firm. • Net Profit, EBIT, EBITDA, ROS, ROI, RONA, EVA Measures typically used to analyze a potential investment or project, where the purpose is to value a projected set of cash flows, taking into account the time value of money and potentially an initial investment. • Payback, Discounted Cash Flow, NPV, IRR, WACC NET PROFIT Important Financial Metrics Definition Net Profit ($) = Sales Revenue ($) – Total Costs ($) Purpose: Net profit measures the profitability of ventures after accounting for all costs. Example: Jamie runs a small import business. Sales Revenue is $100,000 Total Costs are $80,000 Net Profit ($) = $100,000 -$80,000 = $20,000 NET PROFIT Net Profit Earnings Before Interest and Taxes Definition EBIT ($) = Net profit ($) + Interest Payments ($) + Taxes ($) Purpose: 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. Example: Jamie paid interest of $4,000, taxes of $3,000, Net Profit is $20,000 EBIT ($) = $20,000 + $4,000 + $3,000 = $27,000 EARNINGS BEFORE INTEREST, TAXES, DEPRECIATION, & AMORTIZATION (EBITDA) EBIT Earnings Before Interest, Taxes, Depreciation, Amortization Definition EBITDA ($) = Net profit ($) + Interest Payments ($) + Taxes ($) + Depreciation and Amortization Charges ($) Purpose: EBITDA is a rough measure of operating cash flow, which reduces the effect of accounting, financing, and tax polices on reported profits. Example: Jamie paid interest of $4,000, taxes of $3,000, and charged $2,000 to depreciation Net Profit is $20,000 EBITDA ($) = $20,000 + $4,000 + $3,000 + $2,000 = $29,000 EARNINGS BEFORE INTEREST, TAXES, DEPRECIATION, & AMORTIZATION (EBITDA) EBITDA Definition NOPAT ($) = EBIT x (1 – Tax Rate) Purpose: 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 more realistic performance measure of the actual cash yield. Example: Jamie has net profit of $20,000 paid interest of $4,000 and a tax rate of 30%. NOPAT ($) = ($20,000 + $4,000) * (1 - .30) = $16,800 EARNINGS BEFORE INTEREST, TAXES, DEPRECIATION, & AMORTIZATION (EBITDA) NOPAT Net Operating Profit after Taxes Definition ROI = Return on Sales (%) = Net Profit ($) / Sales Revenue ($) Purpose: Return on Sales is an indicator of profitability, often used to compare profitability of companies and industries of differing sizes. Example: Sales Revenue is $100,000 Net Profit is $20,000 Return on Sales -- ROS (%) = $20,000 / $100,000 = 20% RETURN ON SALES (ROS) Return on Sales (ROS) Definition ROI = Return on Investment (%) = Net Profit ($) / Investment ($) Purpose: Return on Investment is one way of considering profits in relation to capital invested. Example: Jamie’s business started with an investment of $80,000. Net Profit is $20,000 Return on Investment (ROI) = $20,000 / $80,000 = 25% RETURN ON INVESTMENT (ROI) Return on Investment (ROI) Definition ROI = Return on Investment (%) = Net Profit ($) / Net Assets ($) Purpose: 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. Example: Jamie’s business started has assets of $50,000 and cash for operations of $10,000. Net Profit is $20,000 Return on Net Assets (RONA) = $20,000 / $60,000 = 33% RETURN ON INVESTMENT (ROI) Return on Net Assets (RONA) Definition EVA = Net Operating Profit After Tax ($) – Cost of Capital ($) Purpose: Unlike percentage measures of return (e.g., ROS or ROI), Economic profit is a dollar metric. It reflects not only the “rate” of profitability, but also the size of the business (sales and assets). Example: Net Operating Profit After Tax (NOPAT) excludes items irrelevant to “operations”. If NOPAT is $24,000 and cost of capital is $4,000, then Economic Profit - EVA ($) = $24,000 - $4,000 = $20,000 Economic Value Added -- EVA® is a Stern Stewart & co. trademark ECONOMIC PROFIT (AKA EVA®) Economic Profit (aka EVA®) Definition Payback (#) = the number of periods required to payback or return the initial investment. Purpose: Payback measures how quickly an investment is returned. A quicker return of investment allows re-use of funds and is usually lower risk. Example: Jamie’s business had an investment of $80,000. Net Profit is $20,00 each year. Payback (#) = $80,000 / $20,000 = 4 years to payback investment PAYBACK Payback Definition to convert a future cash flow to its current value, use 1 (1 + Discount Rate)Period Purpose: Discounted Cash Flow compensates for inflation and risk inherent in future cash flows (aka the time value of money) and is the basis for Net Present Value (NPV) analysis. Example: Annual Cash Flow $20,000, 5% Discount Rate Discount Rate Year 1 2 3 4 5 Undiscounted Cash Flow $ 20,000 $ 20,000 $ 20,000 $ 20,000 $ 20,000 Discount Formula 1/(1 + Discount Rate)^Year 1/(1 + Discount Rate)^Year 1/(1 + Discount Rate)^Year 1/(1 + Discount Rate)^Year 1/(1 + Discount Rate)^Year Sum of Discounted Cash Flows 5.00% Discount Mult 95.2% 90.7% 86.4% 82.3% 78.4% Discounted Cash Flow $ 19,047.62 $ 18,140.59 $ 17,276.75 $ 16,454.05 $ 15,670.52 $ 86,589.53 DISCOUNTED CASH FLOW (DCF) Discounted Cash Flow (DCF) Definition NPV = the discounted value of future cash flows minus the initial investment Purpose: Net Present Value allows comparison of investments. It accounts for future profits or cash flows being less valuable than current ones due to the time value of money. Example: Jamie has a potential project that is projected to earn $20,000 a year for 5 years. The project requires an $80,000 investment today. Discount rate is 5% & investment is $80,000. Sum of Discounted Cash Flows = $86,590. Net Present Value = $86,590- $80,000 = $6,590 NET PRESENT VALUE (NPV) Net Present Value (NPV) Definition IRR = Internal Rate of Return (%) = the discount rate for which the net present value of the investment is zero Purpose: The Internal Rate of Return is the percentage return made on the investment over a period of time. Example: Invested $80,000, Cash Flow $20,000 for 5 years. IRR = 7.9% (rounded in example) Discount Rate where NPV=0 Year 1 2 3 4 5 Undiscounted Cash Flow $ 20,000 $ 20,000 $ 20,000 $ 20,000 $ 20,000 Discount Formula 1/(1 + Discount Rate)^Year 1/(1 + Discount Rate)^Year 1/(1 + Discount Rate)^Year 1/(1 + Discount Rate)^Year 1/(1 + Discount Rate)^Year Sum of Discounted Cash Flows Initial Investment Net Present Value 7.93% Discount Rate (@7.9%) 92.7% 85.8% 79.5% 73.7% 68.3% Discounted Cash Flow $ 18,530.39 $ 17,168.76 $ 15,907.19 $ 14,738.32 $ 13,655.34 $ 80,000.00 $ 80,000.00 $ 0.00 INTERNAL RATE OF RETURN (IRR) Internal Rate of Return (IRR) Definition WACC = Weighted Average Cost of Capital (%) = return demanded for capital weighted by how much of each type of capital is held Purpose: Weighted Average Cost of Capital shows how costly it is to raise funds. Risky ventures usually demand a higher WACC. Example: Capital Sources: ½ from a bank at 4% interest & ½ from investors expecting a 6% return Weighted Average Cost of Capital – WACC (%) = 0.5*4% + 0.5*6% = 5% WEIGHTED AVERAGE COST OF CAPITAL (WACC) Weighted Average Cost of Capital (WACC)