Profitability can be calculated using one of three methods: gross profit, net profit, or operating profit.
Operating profit tells you how much money you make from your primary business and how your cash flow is doing. Read on to learn about the operating profit formula, how to calculate it, and the operating profit margin.
What is Operating Profit?
Operating profit is the income generated by a company’s basic operations, excluding any financing or tax-related concerns. The idea is used to assess a company’s profit-making potential while removing all extraneous influences. Operating profit information is especially relevant when plotted on a trend line to see how a company performs over time. If a company’s operating income is negative, it will almost certainly require more outside capital to stay in business.
On a company’s income statement, operating profit is shown as a subtotal after all general and administrative expenses and before the line items for interest income and interest expense, as well as income taxes.
Operating profit does not always correlate to cash flows created by a corporation, because accounting entries made under the accrual method of accounting might result in operating profits that are significantly different from cash flows being reported.
Aggressive accounting methods, such as modifying accounting reserves, changing revenue recognition policies, and/or delaying or accelerating expense recognition, can artificially modify operating profit.
When a company’s financing or tax costs are especially high, it may try to highlight its operating earnings rather than its net profits. If this is the case, management is most likely seeking to divert attention away from significant non-operating expenditures that are a long-term component of the business’s cost structure and cause it to have unusually low net profits.
Operating Profit Formula and Calculation
Operating Profit =Revenue – Cost of Goods Sold (COGS) – Operating Expenses – Depreciation & Amortization
Given the gross profit formula (Revenue – COGS), the operating profit formula is generally simplified as Gross Profit – Operating Expenses – Depreciation – Amortization.
What Can Operating Profit Tell You?
Because it excludes all extraneous factors from the calculation, operating profit is a very accurate predictor of a company’s health. All expenses required to keep the business functioning are included, which is why operating profit includes asset-related depreciation and amortization—accounting tools resulting from a company’s activities.
Operating profit is often referred to as operating income and earnings before interest and tax (EBIT), albeit the latter is incorrect because it includes non-operating income, which is not a component of operating profit. If a company has no non-operating income, its operating profit equals EBIT.
Companies can choose to publish their operating profit figures instead of their net profit figures because a company’s net profit includes the effects of interest payments and taxes. If a corporation has a particularly large debt load, operating profit may represent the company’s financial status more favorably than net profit.
While positive operating profit indicates a company’s overall health, it does not ensure future profitability. As an example, a corporation with a large debt load may display a positive operating profit despite enduring net losses. Furthermore, big but unnecessary costs are not included, which may result in a corporation with a negative net profit having a positive operating profit.
Operating Income Exclusions
Except for things manufactured expressly for the purpose of being sold as part of the main company, revenue generated through the sale of assets is not included in the operating profit number. Furthermore, the interest generated from cash accounts, such as checking or money market accounts, is not included.
While removing manufacturing expenses from overall operating revenue, as well as any depreciation and amortization charges, is permissible when calculating operating profit, the method does not account for any debt commitments that must be met. This is true even though those commitments are directly related to the company’s capacity to continue operating normally.
Operating revenue excludes investment income generated by a partial share in another firm, even if the investment income is closely related to the second company’s fundamental business operations. The sale of assets such as real estate and production equipment is also not included because these sales are not part of the business’s main operations.
Example
Walmart Inc. reported a $22.6 billion operating profit for the fiscal year 2021. Total revenue (including net sales, membership fees, and other income) was $559.2 billion. These earnings come from sales at Walmart’s global network of physical shops, including Sam’s Club, as well as its e-commerce operations.
In the meantime, the cost of sales (or COGS) and operating, selling, general, and administrative expenditures reached $420.3 billion and $116.3 billion, respectively.
What Is Not Included in the Operating Profit?
Except for things manufactured expressly for the purpose of being sold as part of the main company, revenue generated through the sale of assets is not included in the operating profit number. Furthermore, interest received from cash accounts, such as checking or money market accounts, is not included, nor are any debt commitments that must be paid. Finally, it excludes investment revenue derived by a minority share in another company.
What is the Definition of Operating Profit Margin?
Operating Profit Margin is a profitability or performance ratio that indicates the percentage of profit generated by a company’s operations before taxes and interest charges are deducted. It is computed by dividing operating profit by total revenue and expressing the result as a percentage. EBIT (Earnings Before Interest and Tax) Margin is another name for the margin.
Operating Profit Margin varies by industry and is frequently used as a metric for comparing one company to similar companies in the same industry. It can highlight the top performers in the industry and point to the need for additional investigation into why a specific firm is outperforming or falling behind its peers.
How Do You Calculate Operating Profit Margin?
Operating profit is computed by deducting all costs of goods sold, depreciation and amortization, and all applicable operating expenses from total revenues. Operating expenses comprise a company’s expenses that are not directly related to production, such as salaries and benefits, rent and related overhead expenses, research and development costs, and so on. The operating profit margin is calculated as a percentage of total sales divided by operating profit. A 15 percent operating profit margin, for example, equates to $0.15 in operating profit for every $1 in revenue.
What Is the Purpose of Operating Profit Margin?
As a measure of a company’s ability to be profitable, the operating profit margin differs from the net profit margin. The distinction is that the former is based exclusively on its operations, while the latter excludes the financing costs of interest payments and taxes.
An acquirer considering a leveraged buyout is an example of how this profit statistic might be employed. When the acquirer is evaluating the target company, they will be searching for potential operational improvements.
The operating profit margin reveals how effectively the target firm performs in relation to its peers, specifically how efficiently a company controls its expenses to optimize income. The removal of interest and taxes is beneficial since a leveraged buyout would infuse a company with entirely fresh debt, rendering prior interest expenditure meaningless.
Because operating expenses like salary, rent, and equipment leases are variable costs rather than fixed expenses, a company’s operating profit margin reflects how well it is managed. Direct production costs, such as the cost of raw materials used to manufacture the company’s products, maybe beyond a company’s control.
The company’s management, on the other hand, has a great degree of leeway in areas such as how much they want to spend on office rent, equipment, and staffing. As a result, a company’s operating profit margin is generally seen as a more accurate predictor of a company’s management team’s strength than its gross or net profit margin.
The Ratio’s Limitations
Any number of interest, like any other aspect of financial analysis, necessitates more investigation to understand the rationale for the number. Operating profit margin disparities across peers can be related to a variety of causes. A company that pursues an outsourcing strategy, for example, may declare a different profit margin than a company that produces in-house.
When comparing companies, the technique of depreciation may result in variations in operating profit margin. Even though there is no improvement in efficiency, a corporation utilizing a double-declining balance depreciation method may claim lower profit margins that increase with time. Unless some other aspect changes, a corporation utilizing a straight-line depreciation technique will have a constant margin.
When considering operating profit margin as a comparative metric across peers, it is best to keep parameters like region, firm size, industry, and business model consistent. Other profitability measurements, such as Gross Profit Margin or Net Profit Margin, as well as other financial metrics such as leverage, efficiency, and market value ratios, should be considered alongside it.
What Is the Distinction Between Operating Profit and Earnings Before Interest and Taxes (EBIT)?
Earnings Before Interest and Taxes, or EBIT, is another term for operating profit.
However, this is only true for a corporation that does not generate revenue from sources other than its main business of producing and selling a good or service. Non-operational revenue includes dividend income, capital gains from investments, foreign exchange profits, and asset write-downs.
Gross Profit vs. Operating Profit vs. Net Profit
Operating profit is not the same as gross profit or net profit. It can, however, be formed from them and vice versa. Here are three formulas that demonstrate the link between the three profitability measures:
Operating profit = Gross profit – Operating expenses – Depreciation and amortization
Operating profit = Net profit + Interest expenses and taxes.
The operating profit may differ greatly from net profit depending on the degree of non-operational elements, particularly during periods of economic upheaval, industry disruption, changes in corporate or managerial structure, or the presence of large debt loads.
It is conceivable for an organization’s operating profit to exceed its net profit (or even net loss). A corporation may choose to prioritize operating profit over net income; a savvy investor or competitor will consider both in context.
Why Is It Important To Understand Your Operating Profit?
Understanding your operating profit entails understanding your cash flow for everything else, including salary, rent, travel, raw supplies, and energy.
It shows you how much money you make before you have to pay for things you can’t control, such as interest and taxes.
Operating profit demonstrates how successfully you control costs. Year-over-year comparisons reveal trends in pricing strategies, labor expenses, and raw material prices.
Operating profit also provides investors with a fast snapshot of a company’s day-to-day management and decisions. Operating profit establishes a trend line over time that provides insight into management’s adaptability and reactivity to change, as well as a prospective trajectory for a company’s prospects.
Comparing the operating profit of companies in a specific industry can assist an investor in determining if a company is performing better or worse than its competitors and, if all else is equal, how its management measures up as a result.
The operating profit can be used to calculate another important indicator of a company’s profitability: its operating margin.
Operating Profit FAQs
How do you calculate operating profit?
Operating profit is calculated as follows: Revenue – Operating Costs – Cost of Goods Sold (COGS) – Other Day-to-Day Expenses = Operating Profit.
Is operating profit and EBIT the same?
EBIT (earnings before interest and taxes) is a measure of a company’s profitability. EBIT is computed as revenue-less expenses minus tax and interest. Operating earnings, operating profit, and profit before interest and taxes are other terms for EBIT.
Is operating profit same as net profit?
Operating profit is a company’s profit after deducting all expenses excluding debt service, taxes, and some one-time items. Net income is the profit that remains after deducting all expenditures incurred during the period from revenue produced from sales.
