Definition of Net Operating Income
Net operating income is a profitability measure which can be defined as the sum of money earned by an organization from its core business operations, i.e. income figured out by deducting all the operating expenses of the company from its entire operating revenue, whereas all the non-operating expenses like tax expenses, interest, loss on the sale of capital assets are excluded from its calculation.
Explanation
Net operating income is the formula for measuring profitability and is generally used in determining an entity’s net profit generation capacity from its core business activities. For example, in real estate, check a commercial property’s financial health and profit potential by determining the relevant income after deducting all related operating expenses. Creditors use this calculation, investors and other stakeholders to evaluate the business operating efficiency and to further process financial decisions. Any revenue/ expense item will be classified as an operating item if it is related to prime business objectives or is incurred in relation to such revenue generation activities.
The formula for Net Operating Income
Net Operating Income = Operating Revenue – Operating Expenses
Operating Revenue – Operating revenue can be defined as income and earnings made from the day to day business of the company. It is the income generated from the core business of the organisation. Operating revenue provides information about the profitability and productivity of the primary business of the company. It excludes the income from extraordinary items. Few examples of operating revenue depending upon individual business are as follows-
- Sale proceeds from the sale of goods/ services
- Rent income from property
- Service fee
- Parking fees
- Maintenance fee
- Vending machine
Operating Expenses – Operating expenses are the prime cost of the business incurred directly in relation to the core business activity. In simple words, it is the cost to run the day to day operations of the business. Operating expenses are necessary and are unavoidable for the business but does not includes the expenses related to extraordinary items like a loss on the sale of an asset, income tax, interest cost, etc. Few examples of operating expenses are as follows-
- Raw material cost
- Salary and wages
- Power and fuel
- Utilities
- Advertising
Examples of Net Operating Income
Different examples are mentioned below:
Example #1
James is a real estate dealer in New York and owns two malls. He is in an urge to invest in a new project so that he can run and manage the projects better than the current owners. He wants to evaluate two malls’ net operating income, which shows the following details on the income statement.
Amount ($)
| Particulars | Mall 1 | Mall 2 |
| Rent | 3,50,000 | 2,00,000 |
| Property Tax | 40,000 | 50,000 |
| Property Management Fee | 50,000 | 60,000 |
| Repairs | 80,000 | 10,000 |
| Insurance | 30,000 | 5,000 |
Solution:
Net Operating Income is calculated as
Net Operating Income = Operating Revenue – Operating Expenses.
First, we have to calculate operating expenses:
Operating Expenses Mall is calculated as
Operating Expenses Mall = Property Tax + Property Management Fees + Repairs + Insurance
- Operating expenses mall 1 = $40,000 +$50,000 +$80,000 +$30,000
- Operating expenses mall 1 = $2,00,000
Operating expenses mall is calculated as
- Operating expenses mall 2 = $50,000 +$60,000 +$10,000 +$5,000
- Operating expenses mall 2 = $1,25,000
| Particulars | Mall 1 | Mall 2 |
| Operating Revenue | 3,50,000 | 2,50,000 |
| Less: Operating Expenses | 2,00,000 | 1,25,000 |
| Net Operating Income | 1,50,000 | 1,25,000 |
It is clear from the above example that the first mall generates more revenue during the period but has more expenses than mall 2. Therefore, mall 1 has a higher net operating income than mall 2 and is a better option for investment.
Example #2
Rolex Inc. is a worldwide famous watch company and is famous for its high-class watches. Rolex thinks that its debts can be refined and can have better borrowing. In order to do so, Rolex decides to determine its net operating income. For the same, the following data has been received from past year records. All figures in a million dollars
| Particulars | Amount ($) |
| Sales | 2,00,000 |
| Cost of Goods Sold | 50,000 |
| Property Tax | 18,000 |
| Salary and Wags | 40,000 |
| Insurance | 12,000 |
There has been a theft in the company during the financial year. Loss due to theft is estimated at $38,000.
Solution:
Net Operating Income = Operating Revenue – Operating Expenses
| Particulars | Amount ($) | |
| Operating Revenue | – | $2,00,000 |
| operating Expenses | – | |
| Cost of Goods Sold | 50,000 | |
| Property Tax | 18,000 | |
| Salary and Wags | 40,000 | |
| Insurance | 12,000 | |
| Less: Total Operating Expenses | 1,20,000 | |
| Net Operating Income | 80,000 |
Note: Loss due to theft cannot be considered for the calculation of net operating profit as it is an extraordinary item.
How to Interpret Net Operating Income?
The concept of NOI is particularly common in the real estate industry. Entities engaged in real estate business uses NOI to have an unvarnished understanding of cash flows generated from the assets. This is possible because NOI is difficult to manipulate. NOI can be increased only by increasing rents or any other fees, or it can be increased by reducing operating costs. Income tax and interest cost are not considered in the calculation of NOI, which makes it a good source for assessing how well the asset is being managed. It is very important to compare the property’s NOI with that of its competitors in the market. NOI can also be used while analysing different self-owned properties.
NOI is also helpful in trend analysis. This helps in depicting how the property’s NOI has changed over the past several years. A falling NOI is an indicator of corrective action to be taken or can be a signal for the sale of the property. Also, it helps in formulating a bid for the property to be purchased.
In general, one needs to understand the NOI trend keeping into consideration various macro and micro-economic factors. Understanding and analysis of NOI will also help in projecting future business development and growth opportunities.
Advantages
Some of the advantages are given below:
- NOI helps in understanding and analysing the value of an income-generating property/ business cash-generating unit etc.
- It helps investors to distinguish and identify better investment opportunities with a less worthwhile investment.
- It also helps in understanding cash flows generating from the asset.
- NOI tracks and presents the operating efficiency of the asset managed.
- NOI compares different properties, whether owned by the same owner or by competitors.
Disadvantages
Some of the disadvantages are given below:
- NOI doesn’t consider depreciation, taxation interest etc., in the calculation.
- Operating expenses used in the calculation of NOI can be manipulated if the income or expenses are accelerated or deferred by the owner.
- NOI calculation doesn’t consider capital expenditures.
- NOI is not impacted by extraordinary income or expenses, which may have a worthy effect on stakeholder’s decisions.
Conclusion
Net operating income is a financial measure that provides insights into an enterprise’s prime business profit generation capacity. Therefore, the calculation of NOI is very important in the valuation and evaluation of any property. As the NOI is determined, one can start looking at various measures such as maximum loan analysis, cap rate. A more detailed analysis of any project is possible only after ascertaining its NOI.
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