Normalized Operating Income

A key input that drives the optimal capital structure is the current operating income. If this income is depressed, either because the firm is a cyclical firm or because there are firm-specific factors that are expected to be temporary, the optimal debt ratio that will emerge from the analysis will be much lower than the firm's true optimal. For example, automobile manufacturing firms would have had very low debt ratios if the optimal debt ratios had been computed based upon the operating income in 2001 and 2002, which were recession years. If the drop in operating income is permanent, however, this lower optimal debt ratio is, in fact, the correct estimate.

When evaluating a firm with depressed current operating income, we must first decide whether the drop in income is temporary or permanent. If the drop is temporary, we must estimate the normalized operating income for the firm. The normalized operating income is an estimate of how much the firm would earn in a normal year, i.e., a year without the specific events that are depressing earnings this year. Most analysts normalize earnings by taking the average earnings over a period of time (usually 5 years).

Normalized Income: This is a measure of the income that a firm can make in a normal year, where there are no extraordinary gains or losses either from firm-specific factors (such as write offs and one-time sales) or macro economic factors (such as recessions and economic booms).

mgnroc.xls: There is a dataset on the web that summarizes operating margins and returns on capital by industry group in the United States for the most recent quarter.

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Responses

  • alanna
    What is normalized operating income?
    8 years ago

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