Importance Of Understanding Operating Expense While Analyzing Financial Statements

Operating expense is an important term which investors and financial experts often come across while analyzing company’s annual financial report during their financial and investment decision making. The financial report of the business sheds light on its Profit/Loss Statement, Balance Sheet and lastly Income Statement. An increase in operating revenue (reflected in the Income statement) highlights the company’s income earning capacity over the year.  In this context, it becomes essential to understand this concept.

Operating expense is a very significant part of any business. As the name suggests, it is the expense undertaken by the company during its operational activities. In other words, these are unavoidable expenses that the business must incur during its day-to-day operations. Expenses such as rent, legal costs, salary & payroll, utilities, sales commission, property tax, and advertising costs are all operating expenses.

The business can strive to be more profitable by reducing its operating expenditures while standing strong ahead of the cut-throat competition and not compromising on the quality of its product/service offerings.  It can derive various economies of scale to lower its operating expenditures and maximize the operating profit.

The incomes and expenses of a company over a specified period are recorded in the income statement to get an idea of the business profitability. Net Profit is defined as Gross Profit less Cost of Goods Sold & Operating Expenses.

Income statements segregate expenses into six main categories namely Cost of Goods Sold (COGS) and Operating expenses such as selling, general & administrative overhead costs (SG&A), depreciation & amortization (D&A), interest expenses and income taxes.

However, when we calculate or determine the operating income from the income statement, we generally exclude the interest expenses and income taxes. This is one of the reasons for using a standardized technical term for operating income as EBIT, i.e. Earnings before interest and tax.

We can include and treat any expense we can think of, incurred for carrying out a business’s daily activities, as the operating expense, however, we cannot treat costs which are directly associated with production. Expenses directly related to production must be included in the cost of goods sold. So, ideally operating expenses can consist of payroll, sales commissions, employee benefits, and pension contributions, transportation and travel, amortization and depreciation, rent, repairs, and taxes.

Technically speaking the operating expense is a very significant factor to be considered while analyzing the financial health of a business.

An operating income or EBIT gives an idea of how much a business will have a profit (before paying out interest & taxes) after providing for all the necessary expenses for the company to be going. So, in a way, the extent of the operating costs drives the operating profit. The more the operating expense, the business will have less buffer to pay for further interest & taxes, and vice-versa.

Operating expenses can be quite a challenge for a business to control. To mitigate this challenge the management must efficiently and effectively determine how to reduce the operating costs without significantly affecting a firm’s ability to run its daily operations smoothly and compete with its competitors as well. It is a very significant challenge for any business to find and maintain the right balance between these two consistently over time. However, good organizations and their management keep striving to optimize and maintain this balance for the successful performance of the business.


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