Operating income is one of the most useful numbers on the income statement. It shows how much profit a company makes from its core business operations, before interest and taxes come into play. In this guide, we will explain what operating income is, how to calculate it, and why investors pay so much attention to it.
What is Operating Income?
Operating income, also called operating profit or EBIT (Earnings Before Interest and Taxes), measures the profit generated from a company's regular business operations. It excludes income from investments, interest expenses, and taxes.
Why it matters: Operating income isolates how well the core business is performing. It removes the noise from financing decisions and tax situations, giving you a clearer picture of operational efficiency.
How to Calculate Operating Income
There are two common ways to calculate operating income:
Method 1: Top-Down Approach
Operating Income = Revenue - Cost of Goods Sold - Operating Expenses
Example:
- Revenue: $1,000,000
- Cost of Goods Sold: $400,000
- Operating Expenses: $350,000
- Operating Income = $1,000,000 - $400,000 - $350,000 = $250,000
Method 2: Bottom-Up Approach
Operating Income = Gross Profit - Operating Expenses
Using the same example:
- Gross Profit: $600,000 ($1,000,000 - $400,000)
- Operating Expenses: $350,000
- Operating Income = $600,000 - $350,000 = $250,000
What Operating Expenses Include
Operating expenses are the costs of running the business beyond making the product:
- Selling expenses: Sales team salaries, commissions, advertising, marketing
- General and administrative (G&A): Executive salaries, rent, utilities, office supplies
- Research and development (R&D): Product development, innovation costs
- Depreciation and amortization: Spreading asset costs over their useful life
Operating Income vs. Other Profit Measures
Operating Income vs. Gross Profit
Gross profit only subtracts direct production costs. Operating income goes further by subtracting all operating expenses. A company can have strong gross profit but weak operating income if overhead costs are too high.
Operating Income vs. Net Income
Net income is what remains after interest and taxes. Operating income is higher than net income for most companies because it does not include these deductions. Operating income is often more useful for comparing companies because it removes differences in debt levels and tax situations.
Operating Income vs. EBITDA
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) adds back depreciation and amortization to operating income. EBITDA is popular but can be misleading because it ignores real costs of replacing equipment and assets.
Why Operating Income Matters
1. Shows Core Business Performance
Operating income tells you if the fundamental business model works. A company might show profits due to investment gains or tax benefits, but if operating income is negative, the core business is not profitable.
2. Enables Fair Comparisons
Companies have different debt levels and tax situations. Operating income lets you compare operational efficiency across companies without these distortions. This is especially useful when comparing companies in different countries with different tax rates.
3. Reveals Operating Leverage
Operating leverage measures how operating income changes relative to revenue changes. Companies with high fixed costs have high operating leverage, meaning operating income can swing dramatically with revenue changes.
Operating Leverage Example
Two companies each increase revenue by 10%:
- Company A (high fixed costs): Operating income increases 25%
- Company B (low fixed costs): Operating income increases 12%
Company A has higher operating leverage. This amplifies gains when revenue rises but also amplifies losses when revenue falls.
Analyzing Operating Income
Operating Margin Trends
Calculate the operating margin (operating income / revenue) over time:
- Expanding margins: Company is becoming more efficient or has pricing power
- Stable margins: Consistent operational performance
- Contracting margins: Rising costs or competitive pressure on prices
Compare to Industry Averages
Operating margins vary widely by industry:
- Software: 20-40% operating margins are common
- Industrial companies: 10-15% is typical
- Retailers: 5-10% is often considered good
- Airlines: 5-10% in good years, negative in bad years
Quality of Operating Income
Not all operating income is equal. Consider:
- Is it from sustainable operations or one-time events?
- Is the company underinvesting to boost short-term profits?
- Are there significant restructuring charges that might distort the picture?
Red Flags to Watch
- Negative operating income: The core business is losing money
- Operating income declining while revenue grows: Costs are rising faster than sales
- Large gap between operating income and cash from operations: Possible accounting issues
- Frequent one-time charges: May indicate ongoing problems disguised as unusual events
- Operating income heavily dependent on non-operating items: Core business may be weak
Pro tip: Look at operating income before and after stock-based compensation. Some tech companies report strong operating income but give significant amounts away as stock compensation, which dilutes shareholders.
Operating Income in Valuation
Analysts use operating income in several valuation methods:
- EV/EBIT ratio: Enterprise value divided by operating income. Lower ratios may indicate value
- Operating income growth rate: Used to project future profitability
- ROIC calculations: Return on invested capital often uses operating income
Track Operating Income Easily
Pro Trader Dashboard shows operating income trends and margins for any stock. Compare companies and spot trends in operational performance with visual charts.
Common Adjustments to Operating Income
Analysts sometimes adjust reported operating income to get a clearer picture:
- Add back restructuring charges: If they are truly non-recurring
- Remove one-time gains: Such as asset sales
- Adjust for stock compensation: Treat it as a real expense
- Normalize for unusual events: Like pandemic impacts
Summary
Operating income is a powerful metric that shows how profitable a company's core operations are. It removes the noise of financing decisions and tax situations, making it easier to evaluate and compare businesses. Look at operating income trends over time, compare margins to industry peers, and be aware of adjustments that might distort the picture.
Learn more about financial statement analysis with our guides on net income and income statements.