The best way to determine whether your business is successful is to look at its profitability. This is especially true when it comes to startups and side-hustles. If an emerging business can beat the odds to become profitable early on, that’s a great sign that you should keep going!
So, what is the best way to calculate your profitability?
Many people look at operating income. This is the income that is left after you subtract expenses from revenue. Of course, as you might imagine that’s a very simple way of putting. We’ll address the operating income formula that you should use below.
In any case, understanding your profitability is key. If you track this, you will be able to make the needed adjustments to keep your business in the black.
So What is Operating Income?
Operating income is the profit your business makes from its core activities. This means that it does not count extraordinary income. That would be income your business makes that is not related to normal operations.
For example, let’s say that you own an automotive restoration company. Your core activity is restoring classic and luxury cars to factory condition. Now for some reason, a customer asks you to assist them with selling their car. You agree to do so and make $15K in commissions. Since that income didn’t come from your core business operations, it does not count towards operational income.
Operating income also excludes expenses. Another common term you may hear instead of operating income is operating margin. Just know that’s the same thing.
How Operating Income is Different From EBITDA?
What is EBITDA? It’s an acronym that stands for Earnings Before Interest, Taxes, Depreciating, and Amortization. This is a very useful metric to be sure to know as it helps you to understand your cash flow situation and overall business performance. However, it is not exactly the same as operating income.
Many people do consider EBIT or EBITDA to be the same as net operating income, but this is not always the case. Investors and others like to use EBIT as a tool to understand how a company’s core operations are generating income without considering expenses such as taxes or capital structure.
The formula for EBIT is Net Income + Interest costs + Tax Costs. Basically, the deductions from interest and taxes are being added back into Net Income. This is not the formula that is used to calculate operating income. EBITDA will frequently be significantly higher because it adds back cost factors that are excluded when calculating total operating income.
Why Knowing Your Operating Income is Important
Like many other metrics such as break-even point, it gives you a better understanding of your business doings. Once you have your numbers in place, you can interpret those, and make better business decisions. Likewise, investors, potential creditors, and others will use your operating income figures as they make their own decisions relating to your business.
Take a moment and think from the perspective of an investor or a lender. They might compare your operating income to the S&P 500. If your profitability is better than the average S&P 500 return, you are doing better than the market as a whole. That means that you are overcoming market conditions to become more profitable than the average business. That’s great news, right?
Considering that there are several factors that can impact your operating income such as labor costs, overall price quote strategy, raw materials costs etc, it is a good way to measure the competency of your management team, their ability to change adequately depending on current economic conditions, and the effectiveness of their decision making process. If your team can maintain profitability, even during an economic downturn, you are in a good position.
When it comes to comparing operating income with other businesses, it is important to remember that the costs of doing business can vary greatly from one to another. This means that operating income is best used to compare to business is that are in the same industry. That way as many factors as possible are the same, leading to a more accurate comparison.
Finally, because this is a measure of the profitability of your core business, it is a much more stable indicator than other metrics. Since extraordinary income can be so unpredictable and is certainly never guaranteed, it can skew your profitability numbers. It can make your business seem profitable at a given time, even if your core business is really struggling. Conversely, if you lose this income, it can give a false impression that you are struggling, even if your core business is actually performing quite well.
How to Calculate Operating Income: The Formula + Example
Before you can begin to calculate your operating income, you need to gather some figures. You must know your gross income, your operating expenses, your depreciation and amortization, and your extraordinary income and expense items. Here are some definitions to help make each of these items clear:
These are the costs of operating your core business. This includes rent, supplies, commissions to salespeople, legal fees, cost of goods sold, rent, utilities, and insurance. If you haven’t calculated the cost of goods sold (COGS) previously, it is your starting inventory plus new purchases for the given period minus end stock.
Your beginning inventory is the unsold inventory you have on hand that remained unsold in the previous financial period (usually year). New inventory either reflects additional purchases that you made or the cost of producing new goods. When the fiscal period ends, these unsold products are subtracted from the sum of the new inventory and purchases made during that period.
This is your company’s income before taxes or any other deductions have been taken out. Lenders often use this figure to determine how much money you may need to borrow. It is standard for them to limit the credit they extend to you to your gross income.
Depreciation and Amortization
These are the figures that reflect the cost of owning assets over a lifetime. They are included in the expense portion of the standard income statement. Depreciation and amortization is something that is reported for each asset. In most cases, you will see the phrase ‘useful life’ used in conjunction with depreciation and amortization. This refers to the estimated lifespan of a specific asset.
Depreciation is determined by taking its original cost, then subtracting its current resale value. Let’s say that you purchase a painting rig for your restoration business. It costs 15K. You expense that cost over 5 years. Those 5 years reflect the expected life span of your painting rig. At the end of that 5 year period, the resale price of your painting rig is 1K. Your depreciation formula would be (15K – 1K) / 5 years = $2800. That means 2800 dollars per year will be expensed over a period of five years.
Amortization is a bit different as it refers to intangible assets. For example, a licensing agreement, copyright, trademark, or patent would bean intangible assets. They are valuable, but they don’t have a resale value per se.
Operating Income Formula Example
For consistency, it will use the example of the car restoration business mentioned above. You own a car restoration business that focuses on cars and trucks that are more than 50 years old and that cost above six figures. You operate solely on the East Coast but have been training and mentoring your shop manager to run a second operation that you want to open up in San Diego. You’ve found a body shop to purchase in that area at a reasonable price. However, you’re going to have to do quite a bit of remodeling for it to suit your business needs. Long story short, you need a loan.
In order to get a favorable response from lenders, you create an income statement with the goal of demonstrating that your core business is profitable, and is likely to stay that way. Your sales last year 2.5 million dollars. You paid out the following in expenses:
- 36K in Rent
- 12K in Utilities
- 75K in purchasing equipment
- 15K in paint and other consumables
- 25K in total depreciation and amortization
Now that you have these figures, you can calculate your operating income. In your case it would be:
Gross Income – operating expenses – amortization and depreciation = Operating Income
2,500,000 – (36,000 + 12,000 + 75,000 + 15,000) – 25,000 = Operating Income.
That leaves a total of 2,387,000. That amount is your operating income. Because your operating income is positive, you have proof that your business is successfully generating a profit. If you show this to a bank, you are much more likely to receive a loan. This is because they will deem you to be a good risk. You can use this loan can to cover the expenses you will incur while opening the West Coast location of your body shop.
One More Tip For Calculating Operating Margin
The best thing that you can do to ensure that your calculations are accurate and meaningful is to establish some very clear metrics ahead of time. Most important of these are determining what your core business is, and what forms of income and expenses are a part of that. Then, you must be consistent in how you use these numbers. For example, you may offer car detailing as a service, but not consider that part of your core business model. So, you wouldn’t count the profit you make from that. You would also exclude any related expenses. Just browse invoices from vendors to get a better grip of those!
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