The compilation of these Financial Statements Notes makes students exam preparation simpler and organised.
When it comes to the financials of a business, the operating profit is regarded to be a very pivotal element in analyzing the revenue earned for a period. There is a lot more to the term than just some returns on trade. Let us find out what operating profits means and why they hold ample value for a business.
What is Operating Profit?
Operating profit is the income earned from the performance of core operations of a business, excluding any financing or tax-related issues. The concept is used to investigate the profit-making potential of a business, excluding all unusual factors. This information is particularly valuable when monitored on a trend line, to see how a business is performing over a long period of time. If operating income is negative, a business will likely require additional outside funding to remain in operation.
Operating profit is stated as a subtotal on a company’s income statement after all general and administrative expenses and before the line items for interest income and expense, as well as income taxes.
Operating profit does not necessarily equate to the cash flows generated by a business since the accounting entries made under the accrual basis of accounting can result in operating profits being reported that are substantially different from cash flows.
How to calculate Operating Profits?
For calculating the operating profits of a business, the following formula can be used:
Operating Profit = Revenue – (Labour + cost of goods sold + Expenses incurred in the normal course of business)
Operating profits are important because it is an indirect measure of efficiency. The higher the operating profit, the more profitable a company’s core business is.
Several factors can affect the operating profit. These include the pricing strategy of the business, prices for raw materials, or labour costs. This is because these items directly relate to the day-to-day decisions that managers make. Operating profit is also a measure of managerial flexibility and competency, particularly during tough economic times.
While the elimination of production costs from the overall operating revenue, along with any costs that may be associated with depreciation and amortization, are permitted when determining the operating profit, the calculation does not account for any debt obligations that must be met even if those obligations are directly tied to the company’s ability to maintain normal business operations.
Operating income usually does not include any investment income generated through a part stake in another company. This also includes the investment income that may be associated directly with the core business operations of the secondary company. Additionally, the sale of assets such as real estate and production equipment is not included. This is because these sales are not a part of the core operations of the business.
Consider the following figures and calculate EBIT.
- Revenue – 10,00,000 INR
- Cost of goods sold – 5,00,000 INR
- Labour – 3,00,000 INR
- General & administrative expenses – 50,000 INR
EBIT is Earnings before Interest and Taxes. So EBIT, in this case, will be Operating Profits
Operating Profit = INR 1,000,000 – INR 500,000 – INR 300,000 – INR 50,000 = INR 150,000