Analyzing a company's operating results is often the most important aspect of equity analysis. How well a company generates cash flows from operations dictates how well it can satisfy the claims of creditors and create value for common shareholders. In order to assess this value creation, investors do well by analyzing a company's operating income, operating cash flow and operating margins. In this article, we will introduce the components and analysis of operating income. (For background reading, see Zooming In On Net Operating Income.)

Why Are Operating Margins Important?
Operating income is revenue less operating expenses for a given period of time such as a quarter or year. Operating margin is a percentage figure usually given as operating income for some period of time divided by revenue for the same time period. Operating margin is the percentage of revenue that a company generates that can be used to pay the company's investors (both equity investors and debt investors) and the tax man. It is a key measure to analyze a stock's value. Other things being equal, the higher the operating margin, the better. Using a percentage figure is also very useful for comparing companies against or analyzing the operating results of one company over various revenue scenarios.

Revenue can be derived in a number of ways depending on the type of business. Similarly, operating expenses come from a variety of sources. Depending on the source, operating expenses "behave" in a variety of ways.

Analysts often characterize expenses as either "fixed" or "variable" in nature. A fixed cost is a cost that remains relatively steady as business activity and revenue change. A rent expense is an example. If a company leases or rents a property, it usually pays a set amount each month or quarter. This amount does not change regardless of whether business is good or bad at the time. By contrast, a variable cost is one that changes as business activity changes. An example is the cost of buying raw materials for a manufacturing operation. Manufacturing companies must buy more raw materials when business speeds up; therefore, the cost of buying raw materials increases as revenue increases.

Analyzing a company's mix of fixed and variable costs is often important in analyzing operating margins and cash flows. When revenue increases, the operating margins of companies that are fixed-cost intensive have the potential to increase at a faster rate than less fixed-cost intensive companies (the reverse is also true). Because equity analysis involves projecting future operating results, understanding the intensity of fixed costs is vital. Analysts must understand how operating margins will change in the future given certain revenue growth assumptions.

Factoring in the Cost of Goods
A special and important form of expense is cost of goods sold (COGS). For companies selling products that they manufacture, add value to or simply distribute, the cost of products sold is accounted for using inventory calculations.

The basic formula for COGS is:

COGS = BI + P - EI Where: BI is beginning inventory P is inventory purchases for the period EI is ending inventory

COGS strives to measure the cost of inventory sold in a period; the actual amount incurred to buy inventory might be significantly higher or lower. By netting out beginning and ending inventory, companies try to measure the cost of the actual volume of product sold during the period. Also note that a significant amount of overhead costs - like the power bill for a manufacturing plant - is often embodied in inventory amounts and therefore in COGS itself. (For more, see Inventory Valuation For Investors: FIFO And LIFO.)

Revenue less COGS is known as gross profit and it is a key element of operating income. Gross profit measures the amount of profit generated before general overhead costs that are not inventoriable, like selling, general and administrative (SG&A) costs. SG&A costs might include such items as administrative staff salaries or costs to maintain a stock market listing. Gross profit divided by revenue is a percentage value known as gross margin. Analyzing gross margin is paramount in equity analysis projects because COGS is often the most significant expense element for a company. Analysts often look at gross margin when comparing companies or assessing the performance of a single company in a historical context.

Other Considerations
Investors should also understand the difference between cash expenses and non-cash expenses when analyzing operating results. A non-cash expense is an operating expense on the income statement that does not require cash outlay. An example is depreciation expense. According to generally accepted accounting principles (GAAP), when a business buys a long-term asset (such as heavy equipment), the amount spent to buy that asset is not expensed in the same way as rent expense or raw materials cost might be. Instead, the cost is spread out over the useful life of the equipment and, therefore, a small amount of the overall cost is allocated to the income statement over a number of years in the form of depreciation expense, even though no further cash outlay has occurred. Note that non-cash expenses are often allocated to other expense lines in the income statement. A good way to grasp the effect of non-cash expenses is to look carefully at the operating section of the statement of cash flows.

It is largely because of non-cash expenses that operating income differs from operating cash flow. Investors are wise to consider the proportion of operating income that is attributable to non-cash expenses. Analysts often calculate earnings before interest, taxes, depreciation and amortization (EBITDA) to measure cash-based operating income. Because it excludes non-cash expenses, EBITDA may better measure the amount of cash flow generated from operations that is available for investors than operating income. After all, dividends must be paid from cash, not income. Similar to gross margin and operating margin, analysts use EBITDA to calculate EBITDA margin and they use this figure to do company comparisons and historical company analyses. (For more, see The Bottom Line On Margins.)

Conclusion
In order to properly assess most equities, investors must grasp the issuer's ability to generate cash flow from operations. It is therefore vital to understand the concepts of operating income and EBITDA. As with most aspects of financial analysis, numerical comparisons can tell more about a company than the actual financial parameters. By calculating margins, investors can better measure a company's ability to generate operating income in competitive and historical contexts.

by Bryn Harman (Contact Author | Biography)

Bryn Harman, CFA, is a seasoned investment professional with more than 13 years of experience in the fields of corporate finance and investment finance. For the past seven years, his focus has been on bottom-up fundamental analysis of small cap companies. Harman is currently the director of research for a value-oriented investment firm in the Northwest. Bryn has a Bachelor of Commerce from the University of Saskatchewan, Canada.