In Practice Normalizing Operating Income

In estimating optimal debt ratios, it is always more advisable to use normalized operating income, rather than current operating income. Most analysts normalize earnings by taking the average earnings over a period of time (usually 5 years). Since this holds the scale of the firm fixed, it may not be appropriate for firms that have changed in size over time. The right way to normalize income will vary across firms: 1. For cyclical firms, whose current operating income may be overstated (if the economy is booming) or understated (if the economy is in recession), the operating income can be estimated using the average operating margin over an entire economic cycle (usually 5 to 10 years) Normalized Operating Income = Average Operating Margin (Cycle) * Current Sales 2. For firms which have had a bad year in terms of operating income, due to firm-specific factors (such as the loss of a contract), the operating margin for the industry in which the firm operates can be used to calculate the normalized operating income: Normalized Operating Income = Average Operating Margin (Industry) * Current Sales The normalized operating income can also be estimated using returns on capital across an economic cycle (for cyclical firms) or an industry (for firms with firm-specific problems), but returns on capital are much more likely to be skewed by mismeasurement of capital than operating margins.

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