Operating Leverage

Category: Finance KPIs.

If you clicked on this article, you’re probably interested in operating income and what it means. Well, it will tell you what you need to know. Operating income is also called EBIT (Earnings before interest and taxes). Basically, it’s a profitability formula that estimates the profits of a firm derived from operations. Therefore, it calculates how much money a firm makes from the main business activities without including other income expenses not related to the main activities.

If you’d like to find out more about it, then the following paragraphs have what you need.

Operating Income – Why Is It Important?

Operating income is an important concept as it allows investors and creditors to know how well the main business activities are doing. Moreover, it separates the non-operating and operating expenses and revenues in order to give outside users an insight on how the firm makes money.

Also, you should know that the fact that a business shows profit doesn’t indicate a healthy business. It could be the opposite too, in some situations. As an example, a business may lose customers and downside. Consequently, they have to liquidate their equipment and generate cash. So, the main activities are losing cash, while equipment sales are making it. As you can figure, this doesn’t indicate a healthy business.

Therefore, this concept is important for investors and creditors, as they can evaluate the well-being of a company, as well as future potential.

Analyzing Operating Income

As mentioned, the formula is used to allow investors, creditors and company management to measure the profitability, efficiency, and health of the firm. As the definition states, the operating income calculates the profits from the core business activities without taking into consideration huge items. If the operating income is higher, the company will be more profitable, and thus able to repay its debt.

Creditors and investors follow the number closely because it shows them if the company has potential in the future. As an example, if a trending operating profit is positive, it can indicate that the company can possibly grow in the industry. At the same time, a low number shows the opposite.

Because the management is aware of this, it can try to fraudulently modify the ratio by accelerating revenue recognition or delaying the expense recognition. However, these tactics are against GAAP.

What Is the Formula?

This concept has a certain formula, which is calculated by subtracting operating expenses, amortization from gross income and depreciation. The formula should look like this:

Operating Income
Gross Income – Operating Expenses – Depreciation and Amortization

The gross income is calculated when subtracting the goods cost of the goods sold from the net sales. Operating expenses usually include every cost associated with running the main business activities. For instance, they can be wages, utilities, rent, commissions, insurance, and others.

Amortization and depreciation are usually included in this list and used in the operating income equation.
To sum up, operating income lets you calculate the profits of a firm derived from operations. Hopefully, you are now more familiar with the term.

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