Investors and analysts often keep tabs on how companies perform and accordingly decide whether they should invest in them or not. In fact, companies themselves track their own performance and take into account their earnings and profits in order to determine how their operations should proceed in the future. One particular factor that is relevant here is operating income which refers to a company’s earnings before interest and taxes. This article seeks to examine operating income with a microscopic lens.
Operating Income: Meaning
Operating income is a figure that is used in accounting in order to measure the amount of profit that is generated via a company’s operations. This figure is arrived at after taking into account and reducing operating expenses associated with a company’s operations. These include the cost of goods sold (or COGS), depreciation, and wages.
Also called income from operations, this figure is arrived at by taking a company’s gross income (which is equal to its total revenue reduced by its COGS) and deducting all its operating expenses. Operating expenses that a business incurs pertain to the costs associated with its daily activities. Utilities and office supplies fall under these expenses.
Examining All That Operating Income Entails
The operating income metric is able to showcase how much of a company’s revenue will ultimately account for its profits. It may also be called recurring profit or operating profit. This metric is akin to that of earnings before interest and taxes (or EBIT). However, the primary difference between these two metrics is that EBIT accounts for non-operating income generated by a company whereas operating income does not.
Investors often analyze operating income as it doesn’t take into account taxes and other factors that are capable of skewing the profit or net income. Companies that are able to generate an increasing amount of operating incomes are viewed in a favourable light. This is because these figures help convey the fact that the management is able to generate additional revenue while being able to sufficiently control the company’s overhead expenses, production costs, and all other expenses.
Method to Calculate Operating Income
The formula for operating income is as follows.
Operating Income = Gross Income – Operating Expenses
When looking at operating expenses it is important to understand that they include depreciation, amortization, SG&A (or selling, general and administrative expenses) along with other expenses associated with operating a company.
Operating income is used to determine a company’s operating margin which makes clear what the company’s operating efficiency is. Operating income does not include the following.
Investments in other firms which fall under non-operating income
Non-recurrent items like cash paid for a lawsuit settlement
Examples of Operating Income
Companies often take into account what their operating income is when they assess their operational success. Consider the following example which focuses on Company XYZ. This company is a drug manufacturer and also has a hospital. Its operating income has risen by 25% year-over-year such that it amounts to INR 2500 Crores in the first two quarters of its fiscal year. This increase in revenue and operating income is owed to a hike in the number of patients that frequented the XYZ hospital over these two quarters. Moreover, this rise in visits by patients was owed to a new drug released by the company aimed at treating diabetes.
Understanding the Importance of Operating Income
Operating income helps convey the level of efficiency with which a company operates. It indirectly measures the productivity of the company along with its potential to generate additional earnings which can then be used to help expand the company some more. Recurring profit is kept close tabs on by investors who are interested in examining a company’s efficiency over a certain time frame. This helps them determine whether they ought to continue to stay invested in a company or take their money elsewhere. Operating profit also helps determine the business’s worth for a potential buyout. Should the operating profit increase significantly over time, the more efficiently is the company in question’s core business being handled.
Things to Bear in Mind
Operating income must not be confused with net income or gross profit. The former takes into account more expenses in comparison to gross profit which is primarily focused on the costs of production. It also includes both, cost of goods sold, and operating expenses. That being said non-operating income, non-operating expenses, and alternative sources of income are not included under operating income. These figures are included under net income calculations instead.
Those interested in learning what a company’s operating income is can look it up on the company’s income statement. It is ordinarily located close to non-operating income which is also mentioned in this statement. It helps investors differentiate these two categories and helps them ascertain what income came from what sources.