### Measures of Profitability - Management By The Numbers

```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.
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
PROFITABILTY METRICS
Profitability Metrics
2
Jamie runs a small import business and has generated the
following income statement for 2013.
Jamie’s Income Statement 2013
Total Revenue
Cost of Revenue
Gross Profit
\$000
100
45
55
20
Depreciation
10
Operating Income or Loss
Interest Expense
25
5
Pre-Tax Income
20
Income Taxes
6
Net Income
14
We also know that
\$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
MBTN | Management by the Numbers
3
NET INCOME
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
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
Jamie’s Income Statement 2013
Total Revenue
Cost of Revenue
Gross Profit
100
45
55
20
Depreciation
10
Operating Income or Loss
Interest Expense
= \$100,000 - \$86,000
= \$14,000
\$000
25
5
Pre-Tax Income
20
Income Taxes
6
Net Income
?
MBTN | Management by the Numbers
4
Jamie’s Income Statement 2013
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
managerial decision-making.
Total Revenue
\$000
100
Cost of Revenue
45
Gross Profit
55
20
Depreciation
10
Operating Income or Loss
Interest Expense
25
MEASURES OF PROFITABILITY
Other Measures of Profitability
5
Pre-Tax Income
20
Income Taxes
6
Net Income
14
Now let’s
introduce simple
ratio analysis
using these
same measures
MBTN | Management by the Numbers
5
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.
Gr. Profit Margin
Oper. Profit Margin
Pre-Tax Margin
Net Profit Margin
Insight
Jamie’s Income Statement 2013
= \$55 / \$100 = 55%
= \$25 / \$100 = 25%
= \$20 / \$100 = 20%
= \$14 / \$100 = 14%
Total Revenue
Cost of Revenue
Gross Profit
\$000
100
45
55
20
Depreciation
10
Operating Income or Loss
Ratios allow us to compare performance
Interest Expense
Pre-Tax Income
“normalizing” performance. In this
example, by measuring profitability against Income Taxes
sales.
Net Income
MEASURES OF PROFITABILITY RATIOS
Measures of Profitability Ratios
25
5
20
6
14
MBTN | Management by the Numbers
6
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 (\$)
Jamie’s Income Statement 2013
Question 3
Based on the Income Statement
on the right, what was EBIT for
Total Revenue
Cost of Revenue
Gross Profit
100
45
55
20
Depreciation
10
Operating Income or Loss
EBIT = \$14,000 + \$6,000 + \$5,000
= \$25,000
\$000
Interest Expense
25
5
Pre-Tax Income
20
Income Taxes
6
Net Income
14
MBTN | Management by the Numbers
7
Earnings Before Interest, Taxes, Depreciation, Amortization
EBITDA
EBITDA
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 (\$)
Jamie’s Income Statement 2013
Question 4
Based on the Income Statement
on the right, what was EBITDA
Total Revenue
Cost of Revenue
Gross Profit
100
45
55
20
Depreciation and Amortization
10
Operating Income or Loss
EBITDA = \$14,000 + \$6,000 + \$5,000
+ \$10,000
= \$35,000
\$000
Interest Expense
25
5
Pre-Tax Income
20
Income Taxes
6
Net Income
14
MBTN | Management by the Numbers
8
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
Jamie’s Income Statement 2013
Question 5
Based on the Income Statement
on the right, what was the
Effective Tax Rate for Jamie’s
Total Revenue
Cost of Revenue
Gross Profit
Effective
Tax Rate = \$6,000 / \$20,000 = 30%
\$000
100
45
55
20
Depreciation and Amortization
10
Operating Income or Loss
Interest Expense
25
5
Pre-Tax Income
20
Income Taxes
6
Net Income
EFFECTIVE TAX RATE
Effective Tax Rate
14
MBTN | Management by the Numbers
9
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)
Jamie’s Income Statement 2013
Question 5
Based on the Income Statement
on the right, what was NOPAT for
Tax Rate = \$6,000 / \$20,000 = 30%
NOPAT
= \$25,000 x (1 - .30)
= \$17,500
Total Revenue
Cost of Revenue
Gross Profit
\$000
100
45
55
20
Depreciation and Amortization
10
Operating Income or Loss
Interest Expense
25
5
Pre-Tax Income
20
Income Taxes
6
Net Income
14
MBTN | Management by the Numbers
10
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)
Jamie’s Income Statement 2013
Question 6
If Jamie’s company has 10,000
shares issued and with 4,000
targets are met, what are basic
and diluted EPS for 2013?
Basic EPS = \$14,000/10,000 = \$1.40
Diluted EPS = \$14,000/14,000 = \$1.00
Total Revenue
Cost of Revenue
Gross Profit
\$000
100
45
55
20
Depreciation and Amortization
10
Operating Income or Loss
Interest Expense
25
5
Pre-Tax Income
20
Income Taxes
6
Net Income
EARNINGS PER SHARE (EPS)
Earnings Per Share (EPS)
14
MBTN | Management by the Numbers
11
Definition
Return on Investment is one way of considering profits in relation to
capital invested.
Return on Investment (%) = Net Income (\$) / Investment (\$)
Jamie’s Income Statement 2013
Question 7
\$80,000 of capital, what is the
company’s ROI for 2013?
Total Revenue
Cost of Revenue
Gross Profit
100
45
55
20
Depreciation and Amortization
10
Operating Income or Loss
ROI
= \$14,000 / \$80,000
= 17.5%
\$000
Interest Expense
25
5
Pre-Tax Income
20
Income Taxes
6
Net Income
RETURN ON INVESTMENT (ROI)
Return on Investment (ROI)
14
MBTN | Management by the Numbers
12
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 (\$)
Jamie’s Income Statement 2013
Question 8
currently has \$10,000 of cash
and \$50,000 of other assets.
What is the company’s RONA for
2013?
RONA
= \$14,000 / \$60,000
= 23.3%
Total Revenue
Cost of Revenue
Gross Profit
\$000
100
45
55
20
Depreciation and Amortization
10
Operating Income or Loss
Interest Expense
25
5
Pre-Tax Income
20
Income Taxes
6
Net Income
RETURN ON NET ASSETS (RONA)
Return on Net Assets (RONA)
14
MBTN | Management by the Numbers
13
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)
Jamie’s Income Statement 2013
Question 9
If the cost of capital for Jamie’s
business is \$5,000, what is the
Total Revenue
Cost of Revenue
Gross Profit
*Economic Value Added -- EVA® is a Stern Stewart & Co. trademark
100
45
55
20
Depreciation and Amortization
10
Operating Income or Loss
EVA
= \$17,500 - \$5,000
= \$12,500
\$000
Interest Expense
25
5
Pre-Tax Income
20
Income Taxes
6
Net Income
Economic Profit (EVA)
14
MBTN | Management by the Numbers
14
Marketing Metrics by Farris, Bendle, Pfeifer
and Reibstein, 2nd edition, chapter 10.
FURTHER REFERENCE
Further Reference
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.
MBTN | Management by the Numbers
15
```