Summary - How much profit a business makes from its operations (i.e. its operating income) is a key metric that investors use when evaluating a company as a potential investment opportunity. Another way to think about operating income is as an indirect measure of how efficient a business is. The higher the operating income, the more profitable a company's core business will be.
Operating income can fluctuate for a variety of reasons (e.g. pricing strategies, raw material costs, and labor costs). However because these items are directly related to the daily operations of the company, they are considered a measure of how flexible and competent a company's management is, particularly during difficult economic times.
Investment analysts like to look at operating income because it is considered to be one of the Generally Accepted Accounting Principles (GAAP), which means that operating income is not subject to accounting adjustments.
Since interest and taxes (which are not included in the operating income formula) will vary depending on a company and the sector in which it operates, stripping these variables away gives an investor a standard performance measurement which is useful when comparing companies who are in the same industry but who have different capital structures or tax implications. One limitation of operating income is that it is typically only realistic for comparing companies within the same industry. This is due to labor and material costs that may vary widely from sector to sector. Because of this what may seem like a low operating income may be considered normal or even high for a given industry.
Introduction
Profit is central to the success of a business. Of the many profitability measurements available to investors operating income is considered to be one of the most critical. Operating income (which in many cases is the same as Earnings Before Interest and Taxes (EBIT), tells investors how much profit a company makes from its operations after deducting operating expenses. In this article, we'll define what operating income is along with the formula for calculating operating income. We'll also contrast operating income with EBIT and EBITDA including an example of an income statement that clearly shows the difference in all three. We'll conclude by briefly showing how net operating income (NOI) applies to real estate investments and review the limitations of operating income.
What is operating income?
Operating income is the amount of profit a business realizes from its operations after deducting operating expenses. Operating income tells investors how much of a company's revenue should become profit.
To understand operating income and how it is different from other profitability measurements (such as EBIT and EBITDA) it's important to understand what income and expenses are included in this calculation.
Operating income typically excludes items such as interest expenses, nonrecurring items (legal judgments, accounting adjustments or one-time transactions) and any other items that may appear on a company's income statement that are not directly related to a company's core business operations. In many cases, operating income and EBIT will be the same.
Some examples of operating expenses include the cost of goods sold (COGS), wages, depreciation, and amortization. Operating expenses are generally divided into two categories: direct costs and indirect costs. Direct costs include:
- Direct materials and supplies that go into the manufacturing process (spare parts, raw materials, manufacturing supplies)
- Direct labor – those employed to directly manufacture a product (e.g. machine operators, assembly-line operators)
- Power and water consumption that is related to the production process
- Cost of merchandise
- Commissions or professional fees
Indirect costs include:
- Salaries and related benefits of production managers and quality assurance staff
- Maintenance costs and depreciation expense of factor equipment
- Rent of factory facility
- Utilities not directly involved in the manufacturing or purchase of goods
- Insurance and amortizations
- Marketing and advertising costs
- Travel expenses
Operating income is an official measure that is consistent with General Accepted Accounting Principles (GAAP) that a company lists on financial statements such as their income statement and balance sheet. Operating income is used, along with revenue, to calculate the operating margin of a business (i.e. how much profit they earn for every dollar in sales).
To calculate operating income a business starts with their gross income (i.e. total revenue minus COGS). From this number, they will deduct all other operating expenses. Three formulas can be used to calculate operating income:
- Operating Income = Total Revenue – Direct Costs – Indirect Costs
- Operating Income = Gross Profit – Operating Expenses – Depreciation – Amortization
- Operating Income = Net Earnings + Interest Expense + Taxes
These formulas illustrate the difference between revenue and gross profit. Revenue (which is also called net sales) is the amount of cash a business receives from the sale of goods and services. It excludes any merchandise that is returned and any allowances or discounts. Gross income is the amount of revenue that remains after a business deducts the cost of goods sold (COGS) and any sales that are returned + allowances and discounts.
How is operating income different from Earnings Before Interest and Taxes (EBIT)?
When looking at a company's income statement, EBIT includes some additional non-operating income (such as investment income). EBIT is synonymous with operating profit, however, as stated earlier there are some businesses in which EBIT and operating income will be the same.
How is operating income different from EBITDA?
EBITDA (earnings before interest, taxes and depreciation/amortization) is similar to operating income in that they are profitability measurements, but each number means something slightly different.
- Operating income, by definition, does not include non-operating income such as an investment that a business may have in another firm. However, it also does not include taxes and interest expenses as part of the operating expenses. Nor does it include nonrecurring expenses such as any cash that a business may pay to settle a lawsuit.
- Earnings before interest, taxes, depreciation, and amortization (EBITDA)is similar to operating income but adds depreciation and amortization costs. EBITDA can be harder to calculate because a business may account for depreciation and amortization in different places on their income statement. For example, a business may include them as part of the cost of goods sold and as part of General and Administrative Expenses. A company's cash flow statement will give a full breakdown of depreciation and amortization.
Example of operating income, EBIT and EBITDA
Here is information is taken from the income statement of Starbucks (SBUX) from September 30, 2018. Values are in 000s.
Total Revenue
$24,719,500
Cost of Revenue
$10,174,500
Gross Profit
$14,545,000
OPERATING EXPENSES
Sales, General and Administrative
$9,491,500
Non-Recurring Items
$224,400
Other Operating Items
$1,247,000
Operating Income
$3,883,300
Additional Income/Expense Items
$2,067,000
Earnings Before Interest and Taxes (EBIT)
$5,950,300
Interest Expense
$170,300
Earnings Before Tax
$5,780,000
Income Taxes
$1,262,000
Minority Interest
$300
Equity Earnings/Loss Unconsolidated Subsidiary
$301,200
Net Income – Cont. Operations
$4,819,500
Net Income (EBITDA)
$4,518,300
As you can see in this example, SBUX had some additional income that added back in after operating income was calculated to come up with their EBIT. After that interest expenses, taxes and some other expenses were subtracted to come up with the net income (or EBITDA).
Limitations of operating income
Operating income is a number that is not subject to accounting adjustments. However, it does not mean that investors do not need to interpret the number as part of their fundamental analysis of a company. The cost of labor or material may vary by industry. It's important, therefore, to make sure you are looking at two companies that are in the same sector to determine what an acceptable level of operating income will be.
How net operating income is used in a real estate investment
Real estate professionals use net operating income (or NOI) to analyze the profitability of an income-producing property by adding in all revenue from the property minus all (reasonably necessary) operating costs. NOI does not include capital expenditures. In the case of NOI, operating revenue may include such things as parking fees, vending machines or on-site laundry machines. Operating costs include maintenance costs, property management fees, legal fees, utilities, property taxes, and repairs. NOI helps real estate investors determine a property's value and provides a basis of comparison between different properties they may be considering purchasing or selling.
The bottom line on operating income
Operating income is one of the most commonly used financial ratios for assessing how valuable a company is as a whole. It is a line item that companies will have on financial statements that are part of their quarterly earnings reports. This makes operating income a good measurement of the success of a business from quarter to quarter. Operating income is a measure of a company's ability to cover its operating expenses and make a profit. Because it does not include interest and taxes, operating income ratios are not a reflection of the net value of the wealth created by a business.
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