Operating income is a measure of profitability that tells investors how much revenue will

eventually become profit for a company.

HOW IT WORKS (EXAMPLE):

The formula for calculating operating income is:

Operating Income = Revenue - Cost of Goods Sold (COGS), Labor, and other day-to-day expenses

Operating income is also called Earnings Before Interest and Taxes (EBIT).

It is important to understand what expenses are included and excluded when calculating operating
income. It typically excludes interest expense, nonrecurring items (such as accounting adjustments, legal
judgments, or one-time transactions), and other income statement items not directly related to a
company's core business operations.

Operating income as a percentage of sales is called operating margin.

WHY IT MATTERS:

Operating income, or EBIT, is important because it is an indirect measure of efficiency. The higher the
operating income, the more profitable a company's core business is.Several things can affect operating
income (such as pricing strategy, prices for raw materials, or labor costs), but because these items
directly relate to the day-to-day decisions managers make, operating income is also a measure of
managerial flexibility and competency, particularly during rough economic times.

Operating income provides investment analysts with useful information for evaluating a company’s
operating performance without regard to interest expenses or tax rates, two variables that may be
unique from company to company, and enables one to analyze operating profitability as a singular
measure of performance. Such analysis is particularly important when comparing similar companies
across a single industry where those companies may have varying capital structures or tax
environments.

NET INCOME

Net income, also called net profit, is a calculation that measures the amount of total revenues that
exceed total expenses. It other words, it shows how much revenues are left over after all expenses have
been paid.

The net income formula is calculated by subtracting total expenses from total revenues. Many different
textbooks break the expenses down into subcategories like cost of goods sold, operating expenses,
interest, and taxes, but it doesn’t matter. All revenues and all expenses are used in this formula.
Net Income Formula

Example

Let’s take a look at the simple equation for this net income example. Aaron owns a database and server
technology company that he runs out of his house. He manages data, security, and servers for many
different medical companies that require strict compliance with federal rules. As such, Aaron is able to
make large amounts of revenue while keeping his expenses low. Here is a list of his income statement
items for the year.

Revenues $200,000

Computer expenses $10,000

Salaries $50,000

Utilities $5,000

Taxes $2,500

Aaron would compute his annual net income by subtracting total expenses ($67,500) from total income.

Net Income Calculator

Since Aaron’s revenues exceed his expenses, he will show $132,500 profit. If Aaron only made $50,000
of revenues for the year, he would not have negative earnings, however. Instead, he would have a net
loss of $17,500. The net income definition goes against the concept of negative profits. If the company
loses money, it is classified as a loss. If the company makes money, it is considered income or profits.
GROSS PROFIT

Gross profit margin is a profitability ratio that calculates the percentage of sales that exceed the cost of
goods sold. In other words, it measures how efficiently a company uses its materials and labor to
produce and sell products profitably.

Both the total sales and cost of goods sold are found on the income statement. Occasionally, COGS is
broken down into smaller categories of costs like materials and labor. This equation looks at the pure
dollar amount of GP for the company, but many times it’s helpful to calculate the gross profit rate or
margin as a percentage.

The gross profit percentage formula is calculated by subtracting cost of goods sold from total revenues
and dividing the difference by total revenues. Usually a gross profit calculator would rephrase this
equation and simply divide the total GP dollar amount we used above by the total revenues. Both
equations get the result.

EXAMPLE

Monica owns a clothing business that designs and manufactures high-end

clothing for children. She has several different lines of clothing and has proven
to be one of the most successful brands in her space. Here’s what appears on
Monica’s income statement at the end of the year.

 Total sales: $1,000,000

 COGS: $350,000
 Rent: $100,000
 Utilities: $10,000
 Office expenses: $2,500
Monica has an upcoming meeting with investors and wants to know how to
find gross profit and what method to use. First, we can calculate Monica’s
overall dollar amount of GP by subtracting the $350,000 of COGS from the
$1,000,000 of total sales like this:
As you can see, Monica has a GP of $650,000. This means the goods that
she sold for $1M only cost her $350,000 to produce. Now she has $650,000
that can be used to pay for other bills like rent and utilities.

Monica can also compute this ratio in a percentage using the gross profit
margin formula. Simply divide the $650,000 GP that we already computed by
the $1,000,000 of total sales.

Monica is currently achieving a 65 percent GP on her clothes. This means that for every dollar of sales
Monica generates, she earns 65 cents in profits before other business expenses are paid.

COST OF GOODS SOLD

Cost of goods sold, often abbreviated COGS, is a managerial calculation that measures the direct costs
incurred in producing products that were sold during a period. In other words, this is the amount of
money the company spent on labor, materials, and overhead to manufacture or purchase products that
were sold to customers during the year. Notice that this number does not include the indirect costs or
expenses incurred to make the products that were not actually sold by year-end. It only includes direct
costs for the merchandise that was sold. The purpose of the COGS calculation is to measure the true
cost of producing merchandise that customers purchased for the year.

The cost of goods sold formula is calculated by adding purchases for the
period to the beginning inventory and subtracting the ending inventory for the
period.
The cost of goods sold equation might seem a little strange at first, but it makes sense. Remember, we
want to calculate the cost of the merchandise that was sold during the year, so we have to start with our
beginning inventory.We then add any new inventory that was purchased during the period. This gives us
the total cost of all inventory, but we can’t stop there. We only want to look at the cost of the inventory
sold during the period. Thus, we have to subtract out the ending inventory to leave only the inventory
that was sold.

EXAMPLE

Shane’s Sports is a clothing and apparel retailer with three different locations.
Shane specializes in sportswear and other outdoor gear and requires a good
supply of inventory to sell during the holiday seasons. Shane is finishing his
year-end accounting and calculated the following inventory numbers:

 Beginning inventory: $100,000

 New purchases: $450,000
 Ending inventory: $35,000
Here is how to find cost of goods sold for Shane’s Sports.

As you can see, Shane sold merchandise costing him $515,000 during the
year leaving him with only $35,000 worth of product on December 31.

This information will not only help Shane plan out purchasing for the next
year, it will also help him evaluate his costs. For instance, Shane can list the
costs for each of his product categories and compare them with the sales.
This comparison will give him the selling margin for each product, so Shane
can analyze which products he is paying too much for and which products he
is making the most money on.

OPERATING CASH FLOW

Operating cash flow (OCF), often called cash flow from operations, is an
efficiency calculation that measures the cash that a business produces from
its principal operations and business activities by subtracting operating
expenses from total revenues. Basically, it shows how much cash flow is
generated from the business operations without regard to secondary sources
of revenue like interest or investments.
The operating cash flow formula can be calculated two different ways. The
first way, or the direct method, simply subtracts operating expenses from total
revenues.

This calculation is simple and accurate, but does not give investors much
information about the company, its operations, or the sources of cash. That’s
why GAAP requires companies to use the indirect method of calculating the
cash flows from operations. This method is exactly what it sounds like. It’s an
indirect, round about way to calculate it.
The operating cash flow equation for the indirect method adjusts net income
for changes in all non-cash accounts on the balance sheet. Depreciation and
amortization is added back to net income while it is adjusted for changes in
accounts receivable and inventory.

As you can see, this OCF formula much more complicated, but it gives much
more information about the company’s operations. It’s essentially converting
the operating section of the accrual income statement to a cash basis
statement.

EXAMPLE

Bill’s Guitar Shop is a music retail store that specializes in guitars and other
instruments. Bill’s main competition is Guitar Center and he wants to analyze
ways he can improve his business. Bill’s year-end financial statements show
the following numbers.

 Net income: $100,000

 Depreciation: $10,000
 Change in accounts receivable: +$50,000
 Change in inventory: -$20,000
 Change in accounts payable: -$25,000
Using the indirect method can be confusing because you are converting the
accrual net income to a cash basis net income. Thus, any increase in assets
must be subtracted out, while a decrease in assets must be added back in.
The opposite is true for liabilities. Increases are added back while decreases
are subtracted out. I know this sounds confusing, but you have to think about
it in terms of cash. If inventory went down during the year, it means that
inventory was sold and cash was received. Therefore, a decrease in inventory
must be added back to net income.

Here how to calculate OCF for Bill’s store using the indirect method:

As you can see, Bill was able to generate $55,000 of cash flows from his
operations. This means that Bill’s operations generated enough money to pay
its bills and have $55,000 left over at the end of the year. This money could be
reinvested back into the business by purchasing more inventory, a bigger
storefront, or Bill could pay himself a dividend for a successful year. Either
way, it shows that the retail operations are successful enough to pay the
associated expenses and fund some level of expansion and company growth.

STATEMENT OF RETAINED EARNINGS

The statement of retained earnings is a financial statement that is prepared to

reconcile the beginning and ending retained earnings balances. Retained
earnings are the profits or net income that a company chooses to keep rather
than distribute it to the shareholders.

In other words, assume a company makes money (has net income) for the
year and only distributes half of the profits to its shareholders as a distribution.
The other half of the profits are considered retained earnings because this is
the amount of earnings the company kept or retained.

The retained earnings calculation or formula is quite simple. Beginning

retained earnings corrected for adjustments, plus net income, minus
dividends, equals ending retained earnings. Just like the statement of
shareholder’s equity, the statement of retained is a basic reconciliation. It
reconciles how the beginning and ending RE balances. In other words, how
did the RE balance on January 1 turn into the RE balance on December 31?
Format

This statement has five main sections:

— Beginning RE

— Prior Period Adjustments

— Additions

— Subtractions

— Ending Balance

The beginning equity balance is always listed on its own line followed by any
adjustments that are made to retained earnings for prior period errors. These
adjustments could be caused by improper accounting methods used, poor
estimates, or even fraud. The sum or difference is usually subtotaled at this
point.

Next, additions and subtractions are listed. Additions include net income if the
company is profitable. If the company is not profitable, net loss for the year is
included in the subtractions along with any dividends to the owners. Dividends
are always subtracted from RE because once dividends are declared, the
company owes its shareholders the funds and must take these funds out of its
retained earnings even if they are simply declared and not paid.

The last line on the statement sums the total of these adjustments and lists
the ending retained earnings balance.

Like all financial statements, the retained earnings statement has a heading
that display’s the company name, title of the statement and the time period of
the report. For example, an annual income statement issued by Paul’s Guitar
Shop, Inc. would have the following heading:
Paul’s Guitar Shop, Inc.

Statement of Retained Earnings

For the Year Ended December 31, 2015

Example

Here is an example of how to prepare a statement of retained earnings from

our unadjusted trial balance and financial statements used in the accounting
cycle examples for Paul’s Guitar Shop.

As you can see, the beginning retained earnings account is zero because
Paul just started the company this year. There were no retained earnings in
prior years. Likewise, there were no prior period adjustments since the
company is brand new.

Paul’s net income at the end of the year increases the RE account while his
dividends decrease the overall the earnings that are kept in the business.

This ending retained earnings balance can then be used for preparing the
statement of shareholder’s equity and the balance sheet.