Definition: Operating income, also referred to as earnings before interest & taxes (EBIT), is the bottom line profit recorded on the income statement, and it is generated by the operational activity of an organization.
What Does Operating Income Mean?
What is the definition of operating income? The income statement of any organization is directly impacted by two major factors: revenues and expenses. Revenue is generated from the sale of product, while expenses are generated by the funding of operational activities. In general, when the gross profit of an organization (sales – cost of sales) exceeds the operating expenses (including depreciation and amortization), the organization is said to have generated income from operations. In the case of for-profit, public companies, the EBIT is a critical financial statement figure.
Income from operations is a benchmark used by financial statement users to determine the competency of management and the efficiency of the company’s operations. While many external factors can influence the sales revenue of an organization, the changes in EBIT highlight management’s ability to effectively react to the external forces.
Let’s assume you’ve been provided two years of financial data for a company, and you’d like to determine if management was able to maintain the company’s EBIT during a period of economic recession. During year 1, the company experienced a lot of organic growth, while in year 2 an economic recession had a negative impact on the overall revenue. Let’s take a look at the numbers to see how management ended year 2.
|Year 1||Year 2|
|Sales||$3.0 M||$2.7 M|
|Operating Expenses||($900 K)||($700 K)|
|Depreciation/Amortization||($50 K)||($50 K)|
|Taxes||($112 K)||($110 K)|
Based on the information above, what was the EBIT for each year and how would you rate management’s ability to maintain profitability in year 2?
The answer: in year 1 the company achieved an EBIT of $280 K, or 9.3%; in year 2, the company achieved an EBIT of $276 K, or 10.2%. The figures were derived by multiplying the sales by the gross profit percentage, and then reducing the operating expenses, depreciation, and amortization from the overall gross profit. After calculating the EBIT dollar value, we divided that number by the overall sales value to determine the EBIT percentage.
As you can see, management was very reactive to the economic environment in year 2, and they were able to increase EBIT as a percentage of sales during year 2, even though the sales revenue decreased by 10%.
Define Operating Income: Operating income means the bottom line income reported on the profit & loss statement before taxes and interest.