What is Operating Profit

The value of a business as a going concern is measured by its operating profit as is its capacity to generate operating cash flows.

Calculating Operating Profit

Sales revenue arising from trading activity less the day-to-day costs of running a business describes its operating profit. Profits or losses not associated with trading, such as from investment, interest charges, taxes or the disposal of fixed assets are excluded.

What remains is the profit generated exclusively by the core trading activity (operations) of the business. This both describes the return on investment the business is capable of generating from its operations and its capacity to generate operating cash flows.

Financial Overheads

Non-interest fees such as bank and other financial service charges; for example in respect of charge card transactions or factoring, are included in operating overheads. Interest on the other hand is specifically excluded as that is concerned with external financing, not trading activity.

Operating Profit and Cash

As bank or other lender's are mostly concerned with risk, their interest in operating profit will be focused on how it contributes to operating cash flow.

The long term cash benefits of a strong operating profit will depend on the way it is to be invested. If more of it that the business can reasonably afford is channelled into assets (fixed or current) or distributed as dividends, those benefits will be cancelled out.

Allocating Operating Profits

A strong operating profit is not an end in itself therefore; the expectation must always be that next year will be even better.

Expansion always brings its own short term cash flow pressures though such as increases in accounts receivable, goods on the shelf and probably overheads, which is why any business should always first forecast how much cash that will call for before making decisions on future investments or a sustainable value for dividends.

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