What are Operating Earnings?
Operating earnings are the profit earned after subtracting from revenues only those expenses that are directly associated with operating the business, such as the cost of goods sold (COGS), general and administration (G&A), selling and marketing, research and development, depreciation, and other operating costs. Operating earnings are an important measure of profitability. Because this metric excludes non-operating expenses, such as interest and taxes, it enables an assessment of the company's core business profitability.
- Operating earnings is a measure of the amount of profit realized from a business's core operations.
- It is a useful figure for investors since it doesn't include taxes and other one-off items that might skew net income in a specific accounting period.
- A commonly used measure of a company's profitability is the operating margin, which is the portion of operating earnings to total revenue.
Understanding Operating Earnings
Operating earnings lie at the heart of both internal and external analysis of a company's profitability. The individual components of operating costs can be measured relative to total operating costs or total revenues to assist management in running a company. Many variants of metrics stemming from operating earnings can also be used to compare a given company's profitability with those of its industry peers.
One of these metrics is the operating margin, which is calculated by taking operating earnings as a percentage of total revenues. This measure of earnings is closely tracked by management and investors from one quarter to the next for an indication of the trend in profitability.
Operating Margin=RevenueOperating Earnings
Management uses this measure of earnings to track the profitability of various business decisions over time. External lenders and investors also pay close attention to a company's operating margin because it shows the proportion of revenues that are left over to cover non-operating costs, such as paying interest on debt obligations.
Highly variable operating margins are a prime indicator of business risk. By the same token, looking at a company's past operating margins and trends over time is a good way to gauge whether a big increase in earnings is likely to last.
Example of Operating Earnings
Assume Gadget Co. had $10 million in revenues in a given quarter, $5 million in operating expenses, $1 million in interest expense, and $2 million in taxes. Gadget Co.'s operating earnings would be $5 million ($10 million in revenue – $5 million in operating expenses). Its operating margin is 50% ($5 million in operating earnings/$10 million in revenue). Net income would then be derived by subtracting interest expenses and taxes and then netting out any one-time or unusual gains and losses from the operating earnings. Gadget Co.'s net income is, therefore, $2 million.
Sometimes a company presents a non-GAAP "adjusted" operating earnings figure to account for "one-offs" that management believes are not part of recurring operating expenses. A prime example is restructuring costs. Management may add back these costs to present higher operating earnings on an adjusted basis. However, critics could point out that restructuring costs are not "one-offs" if they occur with some regularity.