b. Operating and Non-operating Income

Operating income is a measure of company income from ongoing operating activi­ties. There are three important aspects of operating income. First, operating income per­tains only to income generated from operating activities. Therefore, any revenues (and expenses) not related to business operations are not part of operating income. Second, and related to the first, operating income focuses on income for the company as a whole rather than for debt and equity holders. This means that financing revenues and expenses (mainly interest expense) are excluded when measuring operating income. Third, operating income pertains only to ongoing business activities. This means any in­come or loss pertaining to discontinued operations is excluded from operating income.

Non-operating income includes all components of income not included in operating income. It is sometimes useful when analyzing non-operating income to separate compo­nents pertaining to financing activities from those pertaining to discontinued operations.

Analysis Implications. The usefulness of operating income arises from an important goal in corporate finance. That is, the desire to separate investing (and operating) deci­sions such as capital budgeting, from those of financing decisions such as dividend policy. Because of this goal, it is necessary to determine a comprehensive measure of company income that is independent of a company’s financing and securities invest­ment decisions. Operating income is one such measure. Note that operating income before taxes is similar to earnings before interest and taxes (EBIT), while operating income after taxes is similar to net operating profit after taxes (NOPAT).

In most cases, operating income can be determined by rearranging the income statement and making proper adjustments for taxes. Still, it is sometimes necessary to draw on more detailed adjustments using information in notes. For example, when a company has operating leases, the entire lease rental is included as an operating expense even though the lease payment includes an interest component. In this case, operating income is understated unless the analyst estimates the interest component and makes the necessary adjustments using note information. It is beyond the scope of this chap­ter to show how to compute operating income. We return to this topic in the financial analysis part of the book.

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