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No matter what industry you’re from – whether in startup, retail or construction, if you run a business you need to have a good understanding of what your numbers tell you.
While you can rely on your accountant or outsourced bookkeeper to help explain what your data are telling you, you’ll have a better control of your company if you know what your financial reports reveal.
However, the truth is not every startup founder or a business owner are savvy with numbers, and that’s where we at miplly are here to help.
In this article, we’ll explain what net income and operating income are, how to compute them, and what is the difference between the two.
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To give you a quick overview, both the net income and operating income are essential metrics that are found in a company’s income statement or what is also known as a profit and loss (P&L) statement.
These metrics both reflect the business’ level profitability; but they also differ in some ways.
Operating income looks at a company’s profit after deducting operating costs, which: include wages, cost of goods sold (COGS) and depreciation.
On the other hand, net income is the company’s overall profits within a time period after subtracting all business expenses from the revenue that was generated from sales.
If you’re looking to bring in more funds for your startup or small business, investors would take a look at these numbers as the operating income indicates how a company is efficiently operating the business, while the net income indicates the company’s profitability.
Understanding Net Income
Also called net profit, net income shows the amount of revenue a company has left after accounting for all its expenses and income in a certain period. It is also referred to as the “bottom line” as it is found at the last line of the company’s income statement.
Why is net income important?
Net income is important as it reveals a company’s earnings within a period after accounting for all aspects of the business. It shows the owners how much money the company has left to pay off debts, pay its shareholders, invest or save.
How is net income calculated?
Net income could be calculated using this formula:
Revenue – COGS – Expenses – = Net Income
Or a simpler formula for it is:
Gross Income – Expenses = Net Income
A company’s net income can be calculated either monthly, quarterly, or annually, whichever works for the business.
Note that a company’s net income can be positive or negative. A positive net income means the company is liquid and has higher revenue than expenses.
In contrast, a negative net income or net loss means the overall expenses of a company exceed the total revenue it generated.
Understanding Operating Income
While net income is more inclusive as it accounts for all of the business’ income and expenses, operating income is the company’s profit after taking away operating expenses (which means the cost of running its day-to-day operations).
It doesn’t include any income or costs that are not related to the company’s core business activities (e.g. impact of taxes or any financial activity).
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Why is it important?
It’s vital to monitor operating income as it shows the ability of the business to generate earnings from the core operational activities of the company.
This metric allows business owners to calculate the operational performance of their business.
Investors would be interested in a company’s operating income as this shows if the company has a healthy financial standing, is growing, and has the ability to pay off debts.
How is operating income calculated?
Operating could be calculated using this formula:
Gross Income – Operating Expenses – Depreciation – Amortization
Now that we have defined the two metrics, let’s take a look at the difference between net income and operating income in terms of their significance and uses.
If you look at your income statement, you may notice that operating income is a significant section of the report.
This metric is highlighted as it reflects the profit generated by the company from its primary business activities.
Since it excludes any one-off income or expense, the number shown in the operating income represents the efficiency of the company’s operational activities.
An investor can compare the operating income of a business from various time periods to identify the business’ profitability and potential growth.
The net income is also an important item in the income statement. However, unlike the operating income, it does include any one-time profit or expense.
A small business, for example, may present a strong operating income but would have to pay some penalties.
This said payment would not impact the company’s operating income but would affect its net income, and therefore, also affect the amount the business has available to pay its shareholders.
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Again take note that operating income only includes revenue and the cost of operations, so taxes are not accounted for in this metric.
Net income, on the other hand, is all inclusive. It accounts the business’ earnings, costs, expenses, taxes, surcharges and other one-off expenses.
This is why you may notice on the income statement that the operating income may have a huge number that could be totally wiped off in the bottom line section of the financial report.
The operating income is used to measure how much of a business’ revenue will eventually become profits.
In particular, it used to compute ROCE or Return of Capital Employed, which is a metric that shows how efficient a company uses its capital, indicating its long-term profitability.
As for net income, it is used to calculate certain ratios including EPS or earning per share, return on assets, and return on equity.
Need help with your financial statements?
Monitoring your operating income, net income, and other numbers are keys to keeping your business running and growing.
A regularly generated income statement (and other financial reports) will help you determine the inflows and outflows of cash in the business, and ultimately, improve your company’s financial standing.
With our experts at miplly, you can leave the number crunching to us so you can focus running the business while getting a better understanding for your finances through our monthly, quarterly or yearly reports.
Let us take the daunting task of preparing your financial reports – start your free trial today.