The way a company measures its profitability is through the income statement. This, along with the balance sheet and cash flow statement, provides managers and investors with much of the information needed to make decisions. The income statement has a format dictated by generally accepted accounting principles.
Operating profit, operating income and earnings before interest and tax, known as EBIT, are synonyms — they all have the same meaning. Operating profit appears on the income statement.
Income Statement Structure
An income statement is a column of numbers. The top block reports gross margin, which is the difference between sales and cost of goods sold. Service companies replace COGS with cost of services sold. Next come blocks for operating expenses, other income, interest and taxes. The final figure is net income, which the accountant adds to the retained earnings account on the balance sheet.
Several forms of income statement are available, including single-step, multi-step, condensed and traditional. The difference among these is the level of detail.
Operating Profit (EBIT)
Operating profit is a company's gross margin minus its operating expenses. The number represents earnings from core operations, but doesn't include items relating to finances, income taxes or extraordinary gains and losses. Operating expenses include the general and administrative expenses of a company, such as:
- Depreciation and Amortization
- Payroll taxes
- Property taxes
- Salaries and wages
- Sales taxes
- Travel and entertainment
You exclude non-operating income and expenses, such as proceeds from a lawsuit or loss from discontinued operations, from the operating income formula.
EBIT vs EBITDA
EBITDA is earnings before interest, taxes, depreciation and amortization. It is an intermediate earnings figure that excludes two non-cash expenses. Depreciation is the wear and tear on a long-term asset, expressed in a series of annual deductions. Amortization is similar, except it reflects consumption of an intangible asset, such as a patent.
Writing off asset values via depreciation and amortization doesn't affect a company's operational cash flows, but does reduce net income.
Net Income Calculation
You can combine interest income and expenses into a single total or report them separately. Include in this category all financing charges, such as capital lease payments and bond amortization. When subtracted from operating profit, the result is taxable income.
The next step is to apply the company's tax rate to operating profit to find income tax expense. When subtracted from taxable income, the result is the company's net income. Investors and analysts closely watch new announcements of net profits to gauge how a company is doing.
Example of EBIT (Operating Income)
A small manufacturer of hair products reported annual revenue of $1 million and the following expenses:
- Cost of goods sold: $400,000
- General and administrative expenses: $300,000
- Interest expense: $40,000
- Income taxes: $90,000
EBIT is equal to $1 million revenue - $400,000 COGS - $300,000 G&A = $300,000. Interest and income tax expenses are excluded from the EBIT calculation. To find earnings before taxes, you subtract the $40,000 interest expense to get $260,000.
However, when calculating net income, the $90,000 in income tax expense is subtracted, giving a figure of $170,000. This represents the company's annual profit.
Basics of Earnings Management
Many analysts prefer to focus on operating profits rather than net earnings, because some feel that these are less prone to manipulation. For example, a company might increase net profit by temporarily paying down debt and therefore saving on interest expenses. Another tactic is to hold earnings offshore to avoid taxes. By concentrating on EBIT or operating profit, an analyst can get a better understanding of how core operations are performing.