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Originally Posted On: https://theaccountancycloud.com/resources/blogs/calculate-operating-profit-for-startups

 

If you’re trying to evaluate your startup and better understand its core profitability, operating profit is a key component. The word core is important here, as operating profit is really only concerned with the core activities of your startup.

It provides a measure of how well your startup is performing and strips away some components which may obscure the core picture. It’s also a useful benchmark when trying to compare different companies in similar markets or industries. Within this blog we will discuss:

• what operating profit is
• why it’s important
• how to calculate it; and,
• provide a worked example

What is operating profit?

What it is in a nutshell…

…the operating profit for your startup is the total earnings from your core business (for any given time period) before any deductions for interest, expenses and tax payments.

Excluded from this operating profit formula is any profits made from supplementary areas of your business or any investments your business may have made. This includes other businesses that your startup might part own.

An operating loss would mean the income from your core business is lower than your expenses.

A company might choose to present operating profit as opposed to net profit if it’s advantageous to their business. For example, if your business has a high debt burden, the operating profit may be a better way to positively present the financial situation of the company.

What operating profit is NOT

EBIT. Which stands for:

Earnings Before Interest and Tax.

Operating profit can be used interchangeably with EBIT in some contexts but please take care. It’s important to understand the subtle difference between the two. EBIT includes non-core income (there’s that word again, core).

If your startup has no non-operating income, then Operating Profit = EBIT. However, this isn’t always true so a distinction should be made, especially so when making comparisons between businesses. Otherwise, your comparison at best lacks nuance, and at worst isn’t meaningful.

Operating profit formula

Operating Profit = (Total Revenue) – (Cost of Goods Sold) – (Operating Expenses) – (Depreciation) – (Amortisation)

What we include in operating profit formulas

• Total Revenue
• Operating expenses
• Cost of goods sold
• Depreciation
• Amortisation

Total Revenue: This is the revenue from all core business operations.

Operating expenses: These are all the fixed cost expenses needed to keep the core business operating, plus amortisation and depreciation of assets. These can include such things as rent, utilities, and payroll.

Cost of goods sold: This represents labour costs and raw materials and other expenses directly related to the production of goods. The cost of goods sold does not include any indirect expenses such as costs relating to maintaining a corporate headquarters.

Depreciation: The allocated cost of a tangible or physical asset over its expected useful lifetime.

Amortisation: The lowering of the value of non-tangible assets over time.

What we exclude from operating profit formulas

• Income from non-core business activities
• Income from investments
• Interest expenses
• Tax expenses
• Business expenses relating to non-core activities

Any revenues generated by selling assets would not be included in the operating profit formulation unless it was related to the core business, for example, assets created for the sole purpose of being sold. If a real estate asset or piece of machinery were sold, this income would not be included as it is not generated as part of the core business operations.

Interest earned from cash, whether held as currency in money markets or held in other accounts, would not be included either.

Debt expenses are not included in the formula. This is always the case for operating profit calculations, even if the debt is needed in order to facilitate the business maintaining its operation.

Total Revenue does not include any revenue generated by non-core activities. This includes investment income from equity stakes in other businesses.

Example

Now we know what operating profit is (and we’ve seen what it isn’t) let’s work through an example.

We want to work out your startup’s operating profit so we can see how you compare to a competitor.

SolarFix has been operating for several years, developing and selling a coating which when added to solar panels increases their efficiency by 25%.

In the last 12 months SolarFix had:

• Revenue: £17m
• Operating expenses: £3.6m
• Cost of goods sold: £6.9m
• Depreciation: £920k
• Amortisation: £500k

Now we can use our operating profit formula.

Operating Profit = (Total Revenue) – (Cost of Goods Sold) – (Operating Expenses) – (Depreciation) – (Amortisation)

Operating Profit = (£17m) – (£3.6m) – (£6.9m) – (£920k) – (£500k)

Operating Profit = £5.08m

Operating profit is important, here’s why…

Operating profit calculations can give people a lot of information about a company. This metric is useful to people both inside and outside of a business. For example, an investor may use this metric to evaluate the core profitability of a company’s operations. Or a founder may want to get an understanding of how their company measures up against others in their industry.

Managers can use this metric to gain insight into how they are able to control costs. The retail price of goods sold, labour costs and the costs of raw materials all have an impact on the cost of goods sold (and therefore operating profit). Management can use this figure to see how changes to these values are impacting the financial performance of the core business and make decisions accordingly. Potential investors may also use this metric to help understand how competent the incumbent management team is.

As explained above, operating profit is not the whole story. A company may choose to present operating profit to showcase strong underlying profitability, however, the net profit of that company may be negative.

This would be the case, for example, if a company had a high debt burden. This company could show positive operating profit while incurring a net loss.

As with all business metrics, context is important and an understanding of how metrics complement each other is essential.

Operating profit margin

Speaking of metrics that complement each other.

Operating profit margin measures the profit that a company makes per £1 of sales (after core business expenses but before interest and tax). It is calculated by first finding the operating profit and then dividing by the company net sales.

The output of the operating profit formula is a value of £s. The output of the operating profit margin formula is expressed as a percentage.

The operating profit margin represents how good a business is at generating profit through the core business. A higher margin is generally considered to be better, but care must be taken when comparing companies, especially so if they operate in different market conditions.

The operating profit margin formula is:

Operating Profit Margin = (Operating Profit / Net Sales)

Let’s try an example using our SolarFix company which had net sales last year of £32m

Operating Profit Margin = (£5.08m / £32m)

Operating Profit Margin = 15.8%

The operating profit margin can really only be used to compare companies that use similar business models and operate in the same market. Operating profit margins can be very different across industries and so using them for competitor analysis can be difficult and often meaningless.

However, operating profit margin can be used to help you understand your fixed costs and manage them effectively. For example, you can finesse the calculation to understand how making changes to your cost of goods sold impacts your operating profit margin. Helping you to develop sales strategies and target discounts from suppliers that will positively impact your margin.

In closing, we’ve seen how operating profit can be used, why it’s important and the limitations it has. Keeping on top of the financial health of your startup is a good habit to get into and metrics such as operating profit are dynamic and user friendly. Its inherent flexibility can give you an insight into how small changes in your business model, or terms of operation, can have an impact on operational profit.

When running a business, the metrics we need can be time-consuming to produce, even straightforward ones. One solution is to integrate your metrics onto a dashboard. A dashboard is a piece of software designed to ensure that all the information that is important to your business is available to you and presented in a simple way. A good dashboard will give an overall picture of the current state of your business while also allowing you to perform a deep dive and get into granular detail when necessary.

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If you’re interested in the financial performance of your company, we’ve created a dashboard that presents your business metrics and other financial information to be viewed in one place. Our dashboard is intuitive and simple to navigate. Our solution sits on top of any existing accounting systems that you have in place and allows you to visualise and manipulate your financial data. Our dashboard offers you real-time financial information allowing you to make informed decisions and supporting your growth plans.

Beyond our market-leading platform, we also offer accounting services. Our best in class finance teams work with you to level up your finance functions and allow you to move into high growth. We carry out all the accounting basics whilst at the same time ensuring that you see the bigger picture. We’ll help you look at how to optimise revenue and margins, and when to go out for funding for investors. Our tax experts can assist you in maximising any available tax credits and relief, allowing you to focus your time and resources on other areas of your business.

As your business embarks on its growth journey, our creative team are here to support you with our ease of access, flexibility and dynamic approach to help you make it a success. We offer companies a market-leading full-stack finance function, helping your business leaders in their decision making by providing access to live information and reporting tools. We don’t just provide software – our dedicated team of financial experts, specialising in tax, payroll and more are ready and waiting to help whenever you need it.

At Accountancy Cloud, we’ve been involved in many success stories and we’ve overseen some of the UK’s fastest-growing brands, showing an average revenue growth across our platform of 3x. We achieve this in collaboration with you by combining the use of business metrics and live financial data (such as operating profit), our powerful software solutions and an award-winning finance team. Through our motivated and personalised service, we can help you to achieve all of your business goals.