Operating Profits Definition
What is an Operating Profit?
Earnings of an organisation from their core operations is known as operating profit. Operating profit is calculated to determine the potential of an organisation to make a profit. Historical operating profits metrics are plotted on a trend line, and further funding decisions are taken accordingly.
An organisation might modify their operating profits to save taxes by incorporating aggressive accounting techniques like non-recognition or accelerating the expenses, showing a delay in transaction to name a few. These practices are adopted for saving taxes or attracting investors interest.
- Operating profit is derived by deducting operational expenses and the cost of goods sold from revenues generated from the core operations.
- Tax, interest and finance related elements are not included while calculating operating profit.
- Investors should consider operating margin instead of operating profit while making investment decisions.
Frequently Asked Questions (FAQS)
What components are excluded while calculating operating profit?
Income generated from the sale of organisational assets like buildings is not included while determining operating profit. Moreover, the income earned from the investment like interest earned is not incorporated. Although, interest income earned through core operation of the business is included. For example, a business income is dependent upon the investments made, then the interest income will be seen as the operating income. A similar context is followed in the case of sale of assets. For example, if an organisation core business is to buy and sell buildings, then the income received from selling buildings will be considered as operating income.
The cost of production is deducted from the revenue. The cost of depreciation and amortisation is also given consideration.
What is the difference between EBIT and operating profit?
Earnings before Interest and Tax (EBIT) is seen as the operating profit of an organisation. However, there is a difference between EBIT and operating profit. EBIT includes non-operational revenues such as foreign exchange aims, capital gains, dividend income or asset write-downs.
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What is the formula of calculating operating profit?
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An investor should give consideration to both net and operating income while making an investment decision.
What is the relevance of operating profit for an organisation?
If an organisation has a complete understanding of their operating profit, then it indicates that they have complete insight regarding the cash flow, i.e., salaries, travel cost, rent paid, energy, and raw material cost (Cost of goods sold). Operating profit projects the income generated by the organisation before interest and tax payments.
Assessment of the operating profits extends the picture regarding the success of the cost control mechanism adopted by the organisation. By comparing the trends, the cost incurred on the raw material, labour or energy can be observed, and the impact of the new strategy can be investigated.
The pricing strategy can be created on the basis of the operating profit trend.
Moreover, the comparison of the operating profit trend with the competitors provides a glimpse regarding the performance of the organisation in the open market.
Operating margins are calculated by the operating profits, which is a key measurement tool for a company’s profitability measurements.
What is the relevance of operating profit for investors?
Through operating profit trend assessment, the decisions taken by the managers on the ground level can be determined. Chiefly, the efficiency of the company in performing its core business activities can be assessed.
The trend line of operating profit reveals the efficiency of the organisation to respond to the changing economic and industrial conditions. Furthermore, the company’s flexibility can be reported. The flexibility and responsive component are crucial as it ensures the long-term sustainability of the business activities.
Lastly, it allows the investor to make a comparison with the industries which have similar capital structure, business model and operations.
What are the limitations of operating profit from investors’ perspective?
Operating profit does not project the profitability but the profit of the organisation. Profitability is the true figure for determining the revenue for a specific period.
Operating profit allows the comparison with the companies from similar industries but cannot be compared with the companies which belong to a different industry. Since their source of revenue and expenses are different, the comparison cannot be undertaken by employing operating profit.
It does not provide the true picture of the industry as the interest from different investments is not included. Moreover, the debt and interest paid are not included. Therefore, investors cannot get the true picture regarding financial decisions taken by the company.
What role can operating margin play for investors?
Unlike operating profit, operating margins provide the profitability metrics. It is a crucial component for investors before making investment decisions, and therefore, it is a part of fundamental analysis.
Operating margin is calculated by dividing revenue by the operating profit, it is also known as the operating profit ratio.
The operating margin is a percentage that allows the comparison among the companies from a similar industry. A good operating margin indicates that the organisation has the revenue to fulfil its fixed cost, interest and taxes related commitments.
A firm with a higher operating margin shows that the firm has a strong cost-effective operations and is exposed to less risk in comparison with the firms with a low margin percentage.