Operating Profit vs. Net Income: An Overview
Two important terms found on any company's income statement are operating profit and net income. Both profit metrics show the level of profitability for a company, but they differ in important ways. Operating profit shows a company's earnings after all expenses are taken out except for the cost of debt, taxes, and certain one-off items. Net income, on the other hand, shows the profit remaining after all costs incurred in the period have been subtracted from revenue generated from sales.
Revenue is the total amount of income from the sale of a company's products or services. For example, revenue for a grocery store would include the sale of everything from produce to dog food. Revenue is found at the very top of an income statement, and all profitability calculations begin with revenue, which is why it's often referred to as a company's "top line" number.
- Operating profit is a company's profit after all expenses are taken out except for the cost of debt, taxes, and certain one-off items.
- Net income is the profit remaining after all costs incurred in the period have been subtracted from revenue generated from sales.
- Operating profit helps to separate a company's profit by showing the earnings from running the business.
- Net income is important because it includes all revenues and costs and is used to calculate earnings per share.
Operating profit is the amount of revenue that remains after subtracting a company's variable and fixed operating expenses. In other words, operating profit is the profit a company earns from its business. The metric includes expenses for the raw materials used in production to create products for sale, called cost of goods sold or COGS. Operating profit also includes all of the day-to-day costs of running a business, such as rent, utilities, payroll, and depreciation. Depreciation is the accounting process that spreads out the cost of an asset, such as equipment, over the useful life of the asset.
Overhead costs, such as sales, general and administrative expenses (SG&A) are also deducted from revenue and reflected in operating profit. Overhead costs are not directly tied to production, such as the expenses for running the corporate office. Please note that some companies list SG&A within operating expenses while others separate it out as its own line item.
Operating profit can be calculated as follows:
Operating Profit = Operating Revenue - COGS - Operating Expenses - Depreciation and Amortization
Operating profit–also called operating income–is the result of subtracting a company's operating expenses from gross profit. Gross profit is revenue minus a company's COGS, which provides the profit from production or core operations. For example, a car manufacturer would show gross profit in the upper portion of its income statement, which represents the revenue from car sales minus COGS and any production costs directly tied to making cars.
Operating profit takes the profitability metric a step farther to include all operating expenses, including those included in the gross profit calculation. As a result, operating profit is all of the profit generated except for interest on debt, taxes, and any one-off items, such as a sale of an asset. This is why operating income is also referred to as earnings before interest and taxes (EBIT). Operating profit represents the earnings power of a company with regard to revenues generated from ongoing operations.
A company's operating profit margin is operating profit as a percentage of revenue. So, if a company had an operating profit of $50 generated from $200 in revenue, the operating margin would be .25 ($50/$200). We multiply by 100 to move the decimal over by two places to create a percentage, meaning it would equal a 25% operating profit margin.
The operating profit margin shows how effective a company is at managing its costs, which providing an evaluation of the strength of a company's management. The margin is best evaluated over time and compared to those of competing firms. A higher operating profit margin means that the company is managing its costs well and earning more in revenue per dollar of sales.
Net income, also called net profit, reflects the amount of revenue that remains after accounting for all expenses and income in a period. Net income is the last line and sits at the bottom of the income statement. As a result, it's often referred to as a company's "bottom line" number.
Net income is the result of all costs, including interest expense for outstanding debt, taxes, and any one-off items, such as the sale of an asset or division. Net income is important because it shows a company's profit for the period when taking into account all aspects of the business. In other words, net income includes revenue, COGS, overhead expenses and operating expenses, operating profit, debt costs, taxes, and any other financial line item that adds or subtracts to the income of the company. Investors may often hear or read net income described as earnings, which are synonymous with each other.
Earnings per Share (EPS)
Businesses use net income to calculate their earnings per share (EPS). Earnings per share is net income divided by the company's outstanding shares of common stock. Companies issue stock to raise money or capital, which is invested in the business to expand operations, grow sales, buy assets, and ultimately increase profit.
Investors typically want to know how much profit is being generated on a per-share basis because it shows how well a company has invested those funds that were raised from issuing stock. A higher earnings per share means a company is growing profits based on the number of stock shares that they've issued. EPS is helpful because it can be used to compare the profit of companies in different industries since it's a universal metric that all publicly-traded companies use for measuring profitability. EPS also shows how well a company's management team is at investing in the long-term financial viability of the company.
If a company can steadily increase its net income over time, its stock share price will likely increase as investors buy up outstanding shares of stock. As a result, a higher EPS typically leads to a high stock price–all else being equal.
Expenses that factor into the calculation of net income but not operating profit include payments on debts, interest on loans, and one-time payments for unusual events such as lawsuits. Additional income not counted as revenue is also considered in the calculation of net income and includes interest earned on investments and funds from the sale of assets not associated with primary operations.
It's important to note that a company can generate a positive number for operating profit but have a loss or report negative net income for the quarter or fiscal year. If, for example, a company generates $100 million in operating profit, but the company has a significant amount of debt on its balance sheet, the interest expense would be deducted from operating profit to calculate net income. If the interest expense was $110 million for the period, the company would record a $10 million loss in net income despite producing $100 million in operating profit.
As a result, all profitability metrics on an income statement should be analyzed, including gross profit, operating profit, and net income to determine where a company is earning its profits or where its losing money.
While both operating profit and net income are measurements of profitability, operating profit is just one of many calculations that occur along the way from total revenue to net income.