The Amount of Money Left Over After the Business Pays Its Expenses
Business profit, often referred to as the bottom line, is the money left over after a business pays all of its expenses. In general, a company's success is measured by how much profit it generates. Corporations often tie management compensation to the company's profit level. The higher a company's profit, the greater flexibility it has to pay dividends to shareholders, make acquisitions or reinvest in the business.
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Profit
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Every business, whether large or small, is unique. Therefore, profit earned varies from company to company. There are many variables that dictate how much a company earns at any given time. In general, profit is sales less cost of goods sold minus all operating expenses. The income statement shows how much the company earned when it reports its financial results. Net profit is the amount of money left over after taxes. Companies that post consistently high profits usually enjoy higher share prices.
Operating Income
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Reported profit may not be truly reflective of a company's earnings power. Financial analysts frequently make adjustments to a company's income statement to obtain a better picture of a company's earnings power. These adjustments produce what is referred to as a company's operating income or income derived from core business activities. Operating income is also referred to as earning before interest and taxes (EBIT) or earnings before interest, taxes, depreciation and amortization (EBITDA).
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Adjustments
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The most common operating income adjustment is to remove depreciation expense from operating expense because it is a non-cash item. Depreciation is the expense allocated over the estimated useful life of the company's assets. Amortization, like depreciation, is also a non-cash expense because it is a company's estimation of intangible expenses such as goodwill. Thus, EBIT and EBITDA remove non-cash expenses such as depreciation and amortization to arrive at a company's operating income. But there may be other items that can artificially inflate or affect a company's operating income. In general, analysts remove non-operating profit and non-recurring expenses from operating income. For example, a subsidiary sold for profit is not considered part of operating income. Likewise, non-recurring or one-time expenses, such as a legal settlement, are not part of operating expenses.
Operating Income vs. Profit
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Operating income is a better measure of a company's earnings potential because it takes into account the core business of the company and is a better gauge of its operating efficiency. In contrast, unusual items make a company's profit appear better or worse than what it really is. Operating income leaves less chance for management to manipulate company earnings. Furthermore, operating income is useful when a company posts a loss because it focuses on general operations which makes it easy to compare similar businesses across the board.
Valuation
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Financial analysts focus on EBIT and EBITDA when valuing companies because it shows a company's long-term earnings potential, as net income or profit fluctuates from year to year. In general, companies that post higher operating income receive higher valuations or enjoy higher share prices, all else being equal.
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References
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