An operating loss occurs when a company’s operating expenses exceed gross profits (or revenues in the case of a service-oriented company). Let’s explore what it means and how it can affect your business.
A company’s operating profit is its profit before interest and taxes. Unlike interest and taxes, operating expenses include costs like cost of goods sold, as well as general and administrative expenses. Companies typically strive to generate enough revenue to cover these operating expenses and produce an operating profit.
An operating loss occurs when this threshold isn’t met. It doesn’t factor in the influence of interest income, interest expense, extraordinary gains or losses, or income or losses from equity investments or taxes. These elements are considered ‘below the line,’ added or subtracted after determining the operating loss or income to arrive at the net income.
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Key Insights
- A company will reflect an operating loss on financial statements when its operating expenses surpass gross profits.
- An operating loss excludes the impacts of interest income, interest expenses, extraordinary gains or losses, equity investments, or taxes.
- It highlights unprofitable operations, indicating the need for cost reduction or revenue enhancement strategies.
- Sometimes, an operating loss reflects short-term overspending aimed at future business expansion.
Significance of Operating Losses
An operating loss signals that a company’s core activities are underperforming, prompting potential strategic shifts to increase revenue or reduce costs. Typically, management can immediately address this by cutting back on expenses, such as layoffs, closing offices or plants, or reducing marketing budgets. Operating losses are often expected for start-ups, where high initial expenses may lead to such temporary financial states.
In most stable scenarios, sustained operating losses suggest declining fundamentals in the company’s offerings. However, this is not necessarily a bad sign if the company is investing in future growth, such as hiring more staff, launching new sales and marketing campaigns, or leasing additional office space to accommodate planned business growth. These short-term investments often lead to several quarters of operating losses until the increased spending brings benefits to the company’s revenue.
Real World Example of Operating Loss
For manufacturers, gross profit translates to sales minus the cost of goods sold (COGS). Consider the case of Huntsman Corporation in 2009, the year the Great Recession began. The company reported an operating loss of over $71 million, with gross profit at $1,068 million. Operating expenses, including selling, general and administration (SG&A), research and development (R&D), restructuring, impairment, and plant closing costs were $1,139 million. This scenario mirrors how significant expenses can outstrip gross profits, leading to operating losses. When adjusting for $152 million in non-recurring costs, Huntsman actually would show an adjusted operating profit of $81 million instead of a loss.
In conclusion, understanding operating losses is crucial for developing informed financial strategies, making adjustments, and setting the stage for long-term profitability.
Related Terms: gross profit, operating expenses, net income.
