What's the Difference Between Operating Income and Net Income?

How can we tell how much profit a company makes? When reading financial news, we often come across three terms: revenue, operating income, and net income. All three describe a company's financial performance, but they have different meanings. Let's start with revenue. Revenue is the amount a company earns from selling products or services. For example, if a bakery sells $100,000 worth of bread in one year, its annual revenue is $100,000. But that doesn't mean the bakery made $100,000 in profit. Running a business involves various expenses. To make bread, the bakery needs to buy ingredients such as flour and butter. It also has to pay its employees, cover rent and electricity, and possibly spend money on advertising to attract customers. When we subtract the expenses associated with running a company's core business from its revenue, the amount left over is called operating income, or operating profit. Suppose the bakery generates $100,000 in annual revenue. It spends $50,000 on ingredients and packaging, plus another $30,000 on wages, rent, and other operating expenses. That leaves the bakery with $20,000 in operating income. But does that mean the bakery gets to keep all $20,000? Not necessarily. Companies can have income and expenses that aren't directly related to their main business operations. For example, if the bakery borrowed money from a bank to open its store, it would have to pay interest on that loan. On the other hand, it might earn additional income by depositing its spare cash in an interest-bearing account or making investments. Companies also generally have to pay income taxes on their profits. Let's assume the bakery pays $5,000 in interest over the year, has no other nonoperating income or expenses, and owes $3,000 in corporate income taxes. After accounting for these amounts, its net income is $12,000. In other words, operating income shows how much profit a company generates from its core business activities. Net income represents the final profit after accounting for other income, expenses, and taxes. So which is more important: operating income or net income? Both are important because they reveal different aspects of a company's financial performance. If operating income increases consistently, it may indicate that the company is becoming better at generating profits from its main business. However, even a company with strong operating income can report little or no net income if it has borrowed too much money and faces large interest payments. The opposite can happen, too. Imagine a company that earns very little from its regular business but makes a substantial gain by selling a piece of land it owns. Depending on how the gain is classified, net income could increase significantly even though the company's core business remains relatively weak. However, a company can't necessarily repeat that kind of gain every year. That's why it's important to understand where a sudden increase in net income comes from. Is the company earning more from its regular business, or did it benefit from a one-time event? It's also important to remember that profit isn't the same as cash. A company may report operating income or net income without having that amount sitting in its bank account. For example, it might have sold products to customers who haven't paid yet, or it might have used cash to purchase new equipment. To understand how cash actually moves through a business, investors also examine the cash flow statement. When evaluating a stock, it's generally more useful to look at how revenue, operating income, and net income have changed over several years than to focus on just one year's results. Revenue can grow while operating income falls if expenses rise even faster. Likewise, an increase in net income may not last if it was driven by a one-time gain. Ultimately, the key difference between operating income and net income comes down to which types of income and expenses are included. Operating income measures the results of a company's core business activities, while net income reflects its overall financial performance after other income, expenses, and taxes. Understanding both figures can help investors look beyond how much profit a company reports and consider more important questions: Where did that profit come from, and how likely is the company to keep earning it in the future?