What Is Operating Income?
Operating Income is a profitability measure and represents the revenue of a business that is left after deducting the cost of goods sold (COGS) and operating expenses. It is regarded as a useful component for many accounting metrics since interest payments, taxes, and other financial expenses aren’t included in the measure yet.
The formula for operating income goes as following:
(-) Cost of goods sold (COGS) are any costs that are directly linked with the production of goods and services that are sold in the given time period. Those include material, manufacturing, and labor costs and will increase in proportion to higher revenues.
= Gross Income/Gross Profit
(-) Operating expenses are the costs associated with the day-to-day operations of a company. Examples of typical operating expenses include sales and marketing costs (S&M), general and administrative expenses such as salaries and rent (G&A), and research and development costs (R&D).
= Operating Income
How Can Operating Income Be Negative?
Operating income makes up a fraction of the total revenues within the business remaining after subtracting all operational costs associated with the revenues. As a consequence, a company can only report negative operating income when the costs of goods sold or the operating expenses exceed and overweight the total revenues.
Company ABC has reported total revenues of $10 million in the last fiscal year. The company’s cost of goods was $5 million. In addition to that, the business spent $500 million in general and administrative costs and $1 million for sales and marketing during the year.
Subtracting all operational costs from $10 million in revenues leads us to an annual operating income of $3,5 million and an operating margin of 35%.
Let’s suppose company ABC also spent an additional $4 million for its research and development department. In that case, the company’s total operating expenses would exceed their revenues by $500,000 which would result in a negative operating income of -$500,000.
What Are the Consequences of Negative Operating Income?
A negative operating income will mostly lead to a negative net income reported by the business as long as there isn’t a substantial non-operating income that exceeds the negative operating income.
How to Interpret a Negative Operating Income
Negative earnings conclude that a business hasn’t been able to generate profits in the given time period, which obviously isn’t a good sign, to begin with. When a company consistently generates negative earnings until the point where it can’t pay its due debt, it may have to face bankruptcy in the worst case.
That being said, it is important to note that a negative operating income can be very common, especially for young companies that will naturally need time to shift from losses to profits as they grow their revenues. This is why it’s important to analyze a company’s individual financial circumstances instead of judging performance purely by profit measures.
Chances are that a young company reporting negative operating income can even turn out to be cash-flow positive, meaning that it is not profitable from an accounting standpoint but already generating positive cash flows in reality.
Dropbox Inc, for instance, hasn’t been able to generate positive operating earnings until 2020. While the company consistently reported negative operating margins in the years previous to that, its cash flows were actually positive and growing consistently over time:
If people had to choose between earnings and cash flows, most would very likely put more attention on cash flows, simply because they reflect the actual cash that is coming in and out of a business while earnings figures are based on various accounting principles that can often blur the actual financial performance of companies.
In most valuation models, investors and analysts determine a company’s intrinsic value based on its ability to generate future cash flows instead of earnings since those represent the actual amount of money that could be distributed out of a business.
The operating income of a business can only be negative when the total operational costs (COGS, operating expenses) exceed the revenues of the company.
A negative operating income will most likely result in a negative net income as long as the business doesn’t report a substantially high non-operating income.
Some companies can report negative earnings while still being cash flow positive. Whether this applies to a company can simply be found out by having a look at the firm’s cash flow statement. Free cash flows should generally be more important than accounting earnings for investors since they represent the actual cash that could be distributed to the shareholders within a company.