# How to calculate net operating profit

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Net operating profit represents the profitability of a company after accounting for cost of goods sold and operating expenses. Operating profit is an important measurement because it allows investors to determine how good a job management is doing at growing a company's profitability. Operating profit does not account for expenses such as interest and taxes, so it is a true measure of the profits of a company's underlying operations, and does not depend on capital structure or one-time expenses. For this reason, operating profit is one of the key metrics that investors use in evaluating a business.

Skill level:
Moderate

### Things you need

• Annual report containing a profit and loss statement

## Instructions

1. 1

Determine a company's revenue, either by taking it off of the profit and loss statement or by multiplying the quantity of goods sold by the average selling price. If you have the company's annual report, revenue will be the first line on the profit and loss statement. Subtract any discounts, rebates or product returns to get a net revenue figure.

2. 2

Subtract the company's cost of goods sold from its net revenue. Cost of goods sold represents the costs the company incurs to produce or source the products it sells. The main components of cost of goods sold include direct labour (that is, the labour associated with making the products), materials used in the products and factory overhead. The resulting number is the company's gross profit.

3. 3

Subtract the company's selling, general and administrative (commonly, "SG&A") expenses from gross profit. SG&A expenses include general expenses such as rent and utilities; selling and marketing expenses; product development expenses such as research and development; and depreciation. The resulting number is operating profit before one-time items.

4. 4

Add back any one-time or nonrecurring expenses that the company may have incurred. For example, if a company recently settled a lawsuit that resulted in a £6 million payment, you would want to add this expense back to the figure calculated in Step 3. One-time items can distort the true operating profits of a company, so they should be added back. Once you have added back the one-time items, you will have the company's net operating profit.

#### Tips and warnings

• You can use the company's net operating profit to calculate its net operating margin. Simply divide the net operating profit by the company's sales. This type of analysis is useful when you are looking at trends in a business. For example, suppose in Year 1 a company generated sales of £32 million and net operating profit of £6 million, which gives you an operating margin of £6 divided by £32, or 20 per cent. Now suppose in Year 2, the company generates sales of £65 million and net operating profit of £9 million, which gives you an operating margin of £9 divided by £65, or 15 per cent. Even though the company's net operating profit has grown by 50 per cent from Year 1 to Year 2, this margin analysis reveals that net operating profit is not growing as fast as sales. You should investigate changes in the company's cost structure to determine why.
• Exclude interest and taxes from your calculation of net operating profit (that is, you should not subtract interest or taxes when making your calculations). Each of these items is outside of the core operations of a company, and should not be considered when evaluating the profitability of those operations.

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