Operating Income & EBIT

What is Operating Income/EBIT?

Operating income, as its name implies, is the income made from a company's core business operations. It is also used interchangeably with EBIT. EBIT stands for earnings before interests and tax. This financial metric measures a company's profitability. Since all the items above tax and income on the income statement are either expenses or income directly related to a company's core operating, EBIT is also referred to as the operating profit, which provides investors a snapshot of the company’s business operation.

Calculation

Here is the formula for operating income:

Operating Income (EBIT)= Revenue - COGS - Operating Expenses-Depreciation-Amortization

Or:

Operating Income (EBIT) = Net Income + Tax + Interest

Usage and Importance of Operating Income

Operating income is one of the most applied measurements of a business’s profitability. Using operating income is necessary for investors because it ignores the effect of tax and other one-off financing items that might have when determining the profitability of a company.

If a company is generating positive and increasing operating income, it indicates that the company is having a healthy management strategy so that the revenue can cover all the expenses.

Operating income (EBIT) is a necessary indicator in the following scenarios:

1. An investor is trying to compare two companies within the same industry. However, due to the difference in company size and structure, the two companies are facing different tax situations. Since the investor purely wants to compare their profitability, it is better to ignore the effect brought by the tax. Operating income then becomes very helpful in this case, because it cuts tax out of the analysis.

2. The investor is trying to compare two companies within a capital-intensive industry, which means that the companies have a huge amount of fixed assets. Some example industries could be manufacturing or real estate industries. The common property of these industries is that they often take a significantly high proportion of debt. This caused the companies to pay lots of interest every year. When the investor purely wants to compare the earning ability of two companies, it is a smart choice to get rid of the effect of interest. This is why Operating income becomes a handy choice in this case.

The beauty of finance is that the usage and application of metrics are not defined merely as mathematical formulas. Investors could develop their own strategies using different evaluation metrics. Apply it in real life and explore more fun applications of operating income by yourself!