Understanding Net Operating Income

Net operating income (NOI) also referred to as Earnings before interest and taxes (EBIT) is the total gain from sales after a business or corporation's operating expenses have been deducted. Sometimes these deductions lead to a net operating loss. 

Net operating income is different from 1) income after interest and taxes, 2) net income and 3) net income available to shareholders because it is income after expenses and not income after interest and taxes. What's more deductions to net income after interest and taxes may also reduce retained earnings and lower profitability calculations such as price to earnings (P/E).

Attributes of net operating income

The net operating income is one of several financial values that assist in clarifying financial positioning. The value is particularly useful in assessing debt management and profitability of a company. A few of the attributes of net operating income include the following:

• Is found in the income statement of company financial records
• Assists financial analysts, managers and shareholders in determining cost efficiency
• Categorizes expenses by item ex. Administrative, research, and marketing expenses
• Can be inputted into ratio analysis ex. Times interest earned (TIE) and Basic earning power (BEP)
• Is also listed in quarterly financial reports and Government tax filings
• Helpful in determining business valuation

How to calculate net operating income and related calculations

Net operating income is a simply calculation and is found by subtracting expenses before interest on debt and taxes on income from revenue which is the same as monetary proceeds from sales. To utilize net operating income (or loss) to gage debt management and profitability the following two ratios can be used. (Brigham & Houston p.107)

• Times Interest Earned (TIE): Earnings before interest and taxes (Net operating income)/Interest charges

• Basic earning power (BEP): Earnings before interest and taxes (Net operating income)/Total assets.

The higher the TIE ratio the better as this indicates a greater amount of operating income in comparison to interest expense on debt. Similarly, the higher the BEP ratio result the better as this indicates a higher operating income return per asset worth.

Net operating income can also be applied to valuation of property (www.realdata.com). Specifically, when divided by capitalization rate i.e. expected return on investor capital, the resulting value can be used as a form of property valuation based on income generated by that property in the form of pre-tax and interest income.

Advantages and disadvantages of net operating income

While the net operating income calculation generally has more advantages than disadvantages, there are a few factors to take into account when reviewing this figure. Specifically, as with all financial statements, the recorded values are from a moment in time and are only a reflection of financial transactions used in the income statement. In other words, a dramatic drop in revenue, client base, economic circumstances, operating costs etc that occur as soon as a day after the issuing of the income statement will not be reflected in that statement's net operating income.

Additionally, since net operating income does not include interest on debt and taxes the numerical value may be misleading if not also understood in the context of net income and net income available to shareholders which are the "bottom lines" of the income statement.

The net operating income is nevertheless a useful and vital financial value that should not be undervalued in terms of financial analysis. It's use in ratios and the income statement is continued in accounting practice for good reason because it does indicate profit margin before interest and taxes and when compared to revenue figures is a good gauge of cost control.

Summary

Net operating income is a financial value found in business and corporate financial statements most notably the income statement. This value is found after operating expenses such as overhead, employee, advertising etc. and before taxes to income and interest on debt are deducted. 

The net operating income is used in financial analysis, reporting, valuation and assessment and is both useful and potentially misleading if not considered in terms of broader financial context, corporate environment conditions and time of reporting. The NOI value is thus a useful but incomplete representation of business income and beneficial in determining financial relationships between operating costs and sales figures.

Sources:

1. http://www.realdata.com/ls/noi.shtml
2. Eugene F. Brigham, and Joel F. Houston. Fundamentals of Financial Management 9th Ed. South-Western, 1999.p277-281.
3. Howard Bryan Bonham CPA, The complete Investment and Finance Dictionary. Avon Media Corporation, 2001.p.62