What is Net Operating Income?

Malcolm Tatum

Net operating income is the gross annual income after all operating expenses have been paid, but before adjustments to the income have been made to cover income taxes, interest payments, and any amount of depreciation or amortization that is applicable. While this figure is of limited value in the greater scheme of managing available resources, it can help a business to get an idea of how much of an impact the operating expenses have on the overall amount of income that is generated through sales and other means. From this perspective, calculating the net operating income can be seen as a helpful tool in identifying areas of the operation that are not performing at optimal levels.

Man climbing a rope
Man climbing a rope

One of the more important factors in successfully operating a business is to create a model that generates the highest amount of income possible, while keeping operational expenses at the lowest level necessary to generate quality goods and services. By accurately identifying the amount of net operating income that is generated within specific periods of time, such as a quarter or calendar year, it is much easier to determine if the company is actually functioning at the highest rate of efficiency. If the degree of operating leverage is not as high as it should be, then steps can be taken to evaluate each area of the operation, and determine how to improve the efficiency and thus lower the overall cost of operations. As a result, the business is able to realize a higher amount of net operating income to cover any non-operational expenses, such as business loans, improvements to company owned facilities, or plans for expansion projects.

Changes in net operating income from one period to the next can often serve as a means of identifying some upcoming trend that will impact the future operation of the company. For example, if a company sees a noticeable drop in income after operating expenses are covered, and this trend continues for two or more accounting periods, company officers may want to look into the reasons for the drop. The root cause may be seasonal drops in sales, less return on investments, or even the increase in the cost of raw materials. Once the reason for the change is identified, the company can take steps to deal with the situation effectively, and thus keep the business on sound financial footing.

While there are several ethical and practical uses for calculating net operating income, there are instances where businesses may choose to engage in a bit of creative or voodoo accounting. This simply means they will attempt to arrange the accounting records of the firm in a manner that downplays the amount of net operating income that is actually generated. Sometimes referred to as cooking the books, the focus is often on finding ways to reduce the tax debt, or to make the amount of income less apparent to investors. The methods used often remain just within the limits of the law, although the ethics of engaging in activities of this type remain highly questionable.

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