Is Operating Income Recognized as a Good Measure of Performance?
Operating income of a company is one of many tools available for an analyst to measure the performance of a company. Other tools include net income, free cash flow, and earnings before interest, taxes and depreciation. Analyzing operating income alone is one way to research a stock, however, a better way would be to use operating income in combination with some of the other tools.
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Operating Income
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The operating income of a company, found on the income statement, is simply the company's income before interest and taxes. It is also known as EBIT, or earnings before interest and taxes. The idea behind operating income is to isolate companies' capital structure choices. Net income includes the impact of a company's capital structure choices, while the operating income does not. This way, if a company chooses to increase debt in its capital structure, the operating income of the company would not be impacted. The company's operating income would still be comparable. On the other hand, the net income would decrease as the company would be facing a bigger interest expense.
Measure Of Performance
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The operating income of a company is one way to measure the performance of the company. It is useful for understanding which expenses impact the company's results the most and it is appropriate to use for return on capital calculations. However, the operating income alone is insufficient as it does not measure the cash flow of a company. Nor does operating income measure how effective the company has been at earning a return on its capital in excess of the cost of capital.
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Operating Income Margin
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Although the operating income figure does not have a lot of use, the operating income margin figure is very valuable. Dividing the operating income by revenue will equal the operating income margin. A higher operating income margin may mean that the company is able to cut costs or increase pricing. A lower operating income margin may mean that the company is facing cost or pricing pressures. Analyzing only operating income may bring a misleading conclusion. For example, the operating income could rise year over year, but the quality of the income could have decreased. One way a company could do that is by cutting prices on its products to boost revenue and operating income. Although this would increase the absolute operating income figure, it would decrease the profitability, as the company would have earned less per product sold.
Cash Flow
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Operating income is not a cash figure and is only an accounting income. Although operating income does give an idea of a performance, a company's value is ultimately dependent on its cash flows. One way to see if a company's cash flow supports the company's operating income is by looking on the cash flow statement. If a company has strong operating income but its cash flow is lacking, that may mean that it is stretching its balance sheet just to report strong operating income figures. If a company's operating income and operating cash flow are both solid, that means the company is in a strong competitive position.
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References
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