An income statement is one of the three fundamental financial statements. This records revenues and expenses to show your profit or loss in the bottom line and explains where you entered or missed the profitability area.
Two critical metrics from an income statement that all stakeholders in a business care about are operating income and net income. In this article, we will discuss both and navigate the difference between operating income and net income.
What operating income shows
Operating income shows profits from the core operations of a business. It excludes all non-operating revenues and non-operating expenses.
Non-operating revenues are the cash inflows that can come into a business from returns on investments, property and assets sales, currency exchange, and others. Similarly, non-operating expenses don't relate to a business's core function or day-to-day operations. Typical non-operating expenses are tax and interest payments.
Losses incurred in investments, property and assets sales, and currency exchange are accounted for as non-operating expenses. There could be other unusual and one-time non-operating costs, such as lawsuit settlement.
How to calculate operating income
By calculation, operating income is gross profit minus operating expenses and depreciation/amortization costs. Simple!
Operating income formula
Any good accountant can calculate the operating income of your business. So, we don't focus on calculations. We want you to have a better understanding of the components and headers that determine the operating income of a company.
Also called gross income, this is in itself an important metric that is accounted for on the income statement. It is calculated by subtracting the costs of goods sold from total sales. The gross profit margin ratio, gross profit divided by total sales, shows how efficiently you are managing COGS and can attract investors.
Revenue sits on the top line of an income statement. It is income generated from the total sales of a company. Costs of Goods Sold (COGS) are the expenses incurred in the production of the product or service. It includes the cost of the raw materials and labor cost. COGS increases with the increase in sales.
Well, operating expenses are the costs incurred so that your business carry out its day-to-day operations. You account for most of the operating expenses irrespective of the fact that you make sales or not.
Operating expenses are generally selling, general, and administrative expenses. Selling expenses include all the costs associated with marketing. General and administrative expenses are usually costs associated with rent, utilities, supplies, office equipment, and salaries.
Depreciation and Amortization Cost
Depreciation is basically the value an asset loses each accounting period till its useful life ends.
To grasp the concept of depreciation and amortization, you need to consider an example first. Suppose you make a purchase of equipment worth $80,000 for your business. Equipment is a tangible asset that has been useful for many years. It is expensed over its useful life rather than going down as a one-time cost in the income statement.
Let's assume that this asset will lose $10,000 in value each year. Thus, the depreciation cost of the equipment is $10,000, with a useful life of 8 years. So, the equipment will be accounted for as an asset in the balance sheet with the depreciation cost of $10,000 accounted for in the income statement for 8 accounting periods.
Amortization is the accounting approach to calculate the value of an intangible asset and spread it over a specific duration, especially its useful life. Amortization takes place for the same amount of assets for each financial year and is calculated straight-line.
Always on the bottom line of your profit and loss statement, net income refers to the profit your business earns in the accounting period. To calculate net income, subtract all the expenses incurred by the company ( general and administrative costs, sales and marketing expenses, and interest expenses) from all revenues earned by the business.
Net income vs. operating income
Net income and operating income both measure the profit of a company. A key difference is that a company's operating income focuses on the core operations form of a business, whereas net income determines overall profitability. Unlike operating income, net income takes into account additional income streams (i.e., non-operating income like the sale of assets). Net income is not an indication of the operating performance but merely the overall earning potential of the company. Investors often want to know the profit from the core operations of a business when they make comparisons of companies in the same industry.
Operating profit margin, or simply operating margin, a critical profitability ratio, is calculated by dividing operating income by total sales (revenue). A high operating margin means high profitability and a strong reputation among financiers and investors.
Moreover, operating margin lets you know if you need to optimize costs. If your operating margin is less than your competitors, there is a message for you. You need to increase sales and cut down operating expenses.
Net income is absolute that considers total revenue and all expenses. Interest and tax payments, as well as one-time gains/losses, are accounted for in the calculation of the net income. Net profit margin, another profitability ratio, is calculated by dividing net income by total revenue.
In a nutshell
To conclude, net income and operating income are both indications of a company's profitability. But net income shows the profit of the entire business, and operating profit indicates the profit of your business's operating activities. And it would be best if you analyzed both metrics to better understand your financial health.