Operating earnings, also known as earnings before interest and taxes (EBIT), is a measure of a company's financial performance. It is calculated by subtracting a company's operating expenses, such as cost of goods sold, depreciation, and other operating expenses, from its total revenues. Operating earnings are important for management because it shows how much profit a company is generating from its current operations, without taking into account any financing activities or taxes. As such, operating earnings provides a true measure of a company's financial performance, which can be used to compare performance across different companies or over time.
Example of operating earnings
- In a retail business, operating earnings is calculated by subtracting the cost of goods sold, employee wages, rent, and other operating expenses from the total revenue generated from sales. For example, if a retail store had total revenue of $200,000, cost of goods sold of $80,000, employee wages of $50,000, and rent of $20,000, their operating earnings would be $50,000 ($200,000 - $80,000 - $50,000 - $20,000).
- In the banking industry, operating earnings is calculated by subtracting the interest expenses, operating expenses, and loan losses from total interest income and non-interest income. For example, if a bank had total interest income of $2,000,000, operating expenses of $800,000, loan losses of $400,000, and non-interest income of $500,000, then their operating earnings would be $1,300,000 ($2,000,000 - $800,000 - $400,000 + $500,000).
- In the manufacturing industry, operating earnings is calculated by subtracting the cost of production, depreciation, and other operating expenses from the total sales revenue generated. For example, if a manufacturing company had total sales revenue of $5,000,000, cost of production of $2,000,000, depreciation expenses of $500,000, and other operating expenses of $400,000, then their operating earnings would be $2,100,000 ($5,000,000 - $2,000,000 - $500,000 - $400,000).
Types of operating earnings
Operating earnings can be categorized into several different types. These types include:
- Gross Operating Earnings: This is the total profit generated from a company's operations, before subtracting any expenses.
- Operating Profit Margin: This is the ratio of a company's operating earnings to its total revenues. It is used to measure the efficiency of a company's operations.
- EBITDA: This stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is a measure of a company's operational profitability, excluding the effects of non-cash charges such as depreciation and amortization.
- Adjusted Operating Earnings: This is a measure of a company's profitability, after factoring in one-time charges or gains, such as the sale of assets or restructuring costs.
- Operating Cash Flow: This is the amount of cash generated from a company's operations, after subtracting operating expenses. It is an important measure of a company's ability to generate cash from its current operations.
Advantages of operating earnings
Operating earnings provides a true measure of a company's financial performance, which can be used to compare performance across different companies or over time. There are several advantages associated with operating earnings:
- Operating earnings provide an accurate measure of a company's performance. This measure is not affected by financing activities or taxes and gives an indication of the company's current financial situation.
- Operating earnings can be used to measure the performance of different departments within a company. For example, a company can use operating earnings to measure the performance of its sales, production, and marketing departments.
- Operating earnings can be used to compare performance over different periods of time. This can help management identify any performance issues and take appropriate action.
- Operating earnings can also be used to evaluate the performance of different companies. This is helpful for investors who are looking to compare different companies and make informed decisions.
Limitations of operating earnings
Operating earnings provide a measure of a company's financial performance, but there are several limitations to keep in mind.
- First, operating earnings do not take into account any financing activities or taxes, which can have a significant impact on a company's financial position.
- Second, operating earnings are subject to manipulation, as companies may use various accounting strategies to boost their operating earnings.
- Third, operating earnings may not accurately reflect the true economic performance of a company, as some non-operating expenses and income may be excluded from the calculation.
- Finally, operating earnings are typically calculated on a short-term basis and do not provide insight into a company's long-term financial health.
- Bhattacharya, N., Black, E. L., Christensen, T. E., & Larson, C. R. (2003). Assessing the relative informativeness and permanence of pro forma earnings and Gaap operating earnings. Journal of Accounting and Economics, 36(1-3), 285-319.
- Brown, L. D., & Sivakumar, K. (2003). Comparing the value relevance of two operating income measures. Review of Accounting Studies, 8, 561-572.