Operating Profits are the segment of the revenue statement that remain after deducting cost of goods sold and operating costs from total revenue or, gross revenue. Knowing what operating profits are will enable a value investor to understand how well a particular company is performing in relation to other companies. After gross profits are calculated, the next step in the financial statement is whether or not a company is printing positive operating profits.
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What are Operating Profits
When you set out to determine how well a company has performed you will look within the financial statements. There are three sections of financial statements for a publicly traded company:
- Income Statement
- Balance Sheet
- Cash Flow Statement
A company’s performance is determined by several metrics. The first is revenue and profits. This is followed by total equity which is shown in the balance sheet.
The Income Statement is broken down into smaller sections:
- Gross Profits
- Operating Profits
- Continuing Profits
These are the three sections of the income statement. But, within these three sections there are several other lines that break down how a company has performed during a period of time.
Operating Profits
In the above example from Nasdaq website, we have the Apple financial statements showing the annual numbers.[1]Nasdaq Apple AAPL Stock Financial Data There was $152B in gross profits and from that R&D of $21.9B and SG&A of $21.9B were subtracted leaving $108B in operating income, or operating profits.
After gross profits are calculated, the next segment is the section on revenue statement is operating profits and this encompasses:
- Sales General, & Administrative
- Depreciation & Amortization
- Research & Development
- Total Operating Costs
- Operating Profits
After total revenue is calculated, and cost of goods sold are deducted, the next segment is operate in costs. These entail the above mentioned Sales, General, & Administrative (SG&A) and Depreciation & Amortization.
This amounts to total operating costs.
These costs are the costs necessary to conduct normal business operations outside of costs necessary to produce the products. Namely, this is the corporate portion of the business.
Sales, General, & Administrative
Total operating costs entail these three main portions of the business. The sales segment would be the division of the company that directly does the marketing and sales of the products produced by the firm.
General would be the mites necessary to run the business that are incurred during the normal course of running the business and are an uncategorized portion of costs. This could be rent on a building used for the corporate officers or the sales team, or any other costs generally incurred by the business that do not have a specific category.
Administrative are costs associated with running the business that are for the administrators such as the CEO, CFO, Human Resources, Investor Relations, and other ares of the business that are incurred by the administrators of the business or firm.
Depreciation & Amortization
In this segment of the line item, any depreciation is deducted from the cost of doing business to allot for the depreciation of capital goods and other business expenses. Also, if any amortization is incurred, it is deducted out of the
Generally, D&A costs are costs incurred by the firm for capital acquisitions and the D&A deductions are the depreciation and amortization of these capital goods over the course of a period of time allotted by tax procedures.
Research & Development
If the firm does any research to invent a new product or bring a product to market, this is where R&D is deducted from revenues and gross profits.
Total Operating Costs
Typically in a financial statement, the firm adds up all costs associated with the operations of the firm and there is a line item showing total operating costs. This is the sum of SG&A, R&D, and D&A.
The sum of all of this is total operating costs. This is used to be deducted from what is remaining from Gross Profits.
In the above examples, you can see how with increased revenues, there are also increased operating costs. Operating costs include both fixed costs, such as the CEO salary, and variable costs such as the sales team and costs associated there. Therefore, as revenues increase, so will operating costs.
While there will be fixed costs that are always there, these fixed costs are outsized when it comes to looking at each individual unit sold. Also, there are variable costs associated with the sale of units. A company may spend more on advertising to draw in more revenue. These sales are part of the marketing strategy and would show up inside the operating costs portion of the income statements.
Operating Profits
When you deduct total operating costs from Gross Profits, what remains is operating profits.
In the above charts, you can see how certain companies fair versus others. Operating profits, being a section itself in the Income Statement, becoming operating profit positive is the second goal after gross profit positive. Remember, operating profits are after gross profits, which deduct cost of goods sold.
And, as you can see in the three above examples, these are varying levels of operating profitability.
Operating Margins
As stated, the remaining portion of gross revenue after COGS are deducted are gross profits. Then, total operating costs are deducted from this to leave total operating profits.
If operating profits are mathematically divided that by total revenue you are left with a metric, a percentage, that is termed operating margins.
Operating margins are the percentage amount that remain after cost of goods and total operating costs are deducted from gross revenues. By understanding this metric, you can compare where one firm is versus another in determining which company is more financially competitive with from a metrics standpoint.
Operating Efficiencies
An interesting metric to understand is operating efficiencies. This is a metric that shows, relative to revenue, how much operating costs are. This metrics shows how efficient a firm is, from costs associated to CEO pay, and other similar expenses to run the corporation relative to total revenue earned in a given period.
At the time of this writing, the S&P 500 is printing about 6% for operating margins – down from mid-teens percentages in previous quarters.[2]CSIMarkets S&P500 Profitability But, that is operating profit margins. While this is an important indicator, it is equally important to see how much operating costs are relative to total revenue.
Improving Operating Efficiencies
Mostly, the S&P 500 is printing roughly 17.5% for operating efficiencies. This means that operating costs are roughly 17.5% of a company’s revenue. Knowing where these metrics are can show an analyst where any one metric is relative to comparable companies. If a company is just starting out, the company will have to fill certain roles despite potentially having very small revenue. This means operating costs will be outsized.
But, operating efficiencies are a mathematical ratio. As revenues increase, a company’s operating efficiencies will improve – meaning, the cost relative to revenue will be smaller.
You are always want the smallest metric possible in this metric. A company’s efficiency, their ability to convert revenue into profits is determined by how well they perform. When a company can convert revenue into profits and do so at a measuredly improved rate, this is a company that will potential see its stock outperform others.
Understanding Operating Profits
When you can firmly grasp each segment of a financial statement and build upon your knowledge of what each metric reveals from a company you are better equipped at analyzing a company as a perspective investment and comparing this company to another.
Top line revenue, or gross revenue, less cost of goods sold for the production of this revenue, yields gross profits. Dividing gross profits over top of gross revenues yields gross margins metric.
Deducting total operating costs, the sum of SG&A, D&A, and R&D from gross profits yield operating profits.
From there, you can build your financial repertoire for understanding how to analyze financial statements.
References
| ↑1 | Nasdaq Apple AAPL Stock Financial Data |
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| ↑2 | CSIMarkets S&P500 Profitability |