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)