Operating profit or operating income is the amount left with the company after subtracting cost of goods sold and other day to day operational expenses such as employee cost, rent, electricity, transportation etc. from the revenues. It is basically the profit a company earns from its core operations (no other sources). For example, operating profit of Maruti Sujuki means the amount it gets from selling cars after subtracting cost of manufacturing and other recurring operating expenses. It is normally reported as the third highlighted line item after revenues and gross profit in the profit and loss statement (P&L statement) or the income statement.
The formula to calculate operating profit is:
Operating Profit Formula:
Operating Profit = Revenue - cost of goods sold - employee cost – other recurring operating expenses
From fundamental analysis perspective, operating profit is a crucial figure to observe as it is the direct indicator of companies operational and managerial efficiency. It is important to note that any money that will flow to shareholders in the form of stock price appreciation or dividends is by and large generated from a company's operations (manufacturing and selling products or services efficiently). As a stock market investor, while choosing a company for investment, one must watch this number closely as it reflects the overall demand of the company's products in the market along with companies manufacturing and sales efficiency. The higher the number, the more efficient and profitable the company’s core business operations are. Having said that, one must keep in mind that manufacturing, sales, general, and administrative expenses vary across sectors and comparison of operational efficiency is more meaningful for companies belonging to the same sector.
Let’s have a look at the operating profit trend of two companies from the auto ancillary sector: Amara Raja Battery and Exide Industries
It’s clear from the chart above that operating profit of Amara Raja has been more uniform in the recent past and we can safely assume that Amara Raja is an operationally more efficient company as compared to Exide Industries. Please note that we are talking about the trend and not the absolute numbers. Number wise, operating profit of Exide is way too higher than Amara Raja and that is attributed to the larger market share of Exide (More revenue than Amara raja).
While analysing operating profit, investors should also keep in mind that for some companies the operating profit follows the economic cycle (Lower in recession and higher in economic boom). Due to this very nature of operational performance, they are called cyclicals (Cement, Auto, Steel etc.). For such companies, the operating profit should be analysed in a larger time frame and the highs and lows should be matched with the economic boom and recession. Any deviation from this behaviour should be a matter of concern and seeks further investigation.
An investment grade company has:
- Upward sloping operating profit in larger time frame
- Smaller gap between revenues and operating profit
- Less variation in the operating profit numbers
If you want to analyse operating profit or operating income of various Indian companies or want to compare operating profit of two companies, please click here.