Operating profit margin is an important financial performance ratio that measures the percentage of profit produced by a company from its operations, prior to subtracting interest charges and taxes. As a key metric when analyzing a company’s profitability, the concept of operating profit margin is important to understand for financial analysts, business owners, and investors alike.
Highlights/ Key Takeaways
- Operating profit margin is an important profitability metric that analysts and investors use when evaluating the financial performance of a company.
- The operating ratio is calculated by dividing a company’s operating profit by its revenue and expressing the result as a percentage.
- Also known as Earnings Before Interest and Tax (EBIT) margin, the metric shows the amount of revenue remaining with the company after covering all the costs and expenses except taxes and interest.
- The value of the operating margin indicates how efficiently a business manages its expenses, as well as provides valuable insights for both business owners and investors.
What Is Operating Profit Margin?
Operating profit margin is a profitability ratio used to find the percentage of the profit a company makes from its operations, prior to deducting interest and taxes.
The operating profit margin meaning is the same as the EBIT margin, or the Earnings Before Interest and Tax margin. In a nutshell, the metric shows how much revenue the company retains after covering virtually all its costs and expenses, aside from interest and taxes - hence its name.
The value of the operating profit margin can be calculated by dividing the operating profit of a company by its total revenue, expressed as a percentage. This ratio indicates how efficiently a company manages its expenses and can provide important information for business managers and external stakeholders alike.
“Operating profit margin is a profitability ratio used to find the percentage of the profit a company makes from its operations, prior to deducting interest and taxes.”
How Is Operating Profit Margin Used?
Operating profit margin is used widely by financial analysts, business managers, and external investors. Let us take a closer look at how exactly the operating margin can be used.
- Benchmarking. The value of a good operating profit margin differs across industries and can be used for benchmarking a company against its competitors within the same industry. By looking at the value of operating profit margin, financial analysts, business owners, and investors can identify the top industry performers and gain insights into why a certain company might be outperforming or underperforming its peers.
- Historical tracking. Internal management often tracks operating profit margins on a historical trend line to identify whether there are any long-term changes that management should consider. An operating margin that increases over time is a good sign, indicating that a company is well-managed. A declining trend may be a cause for concern.
- Company acquisitions. When an acquirer is analyzing a target company, they are not too concerned with that company’s financial structure. Instead, they want to evaluate the core ability of the company to generate earnings. Using operating profit margin provides the information necessary to gauge that ability.
“An operating margin that increases over time is a good sign, indicating that a company is well-managed. A declining trend may be a cause for concern.”
Operating Profit Margin Formula
To calculate the operating profit margin, one would need to divide the company’s operating profit by its revenue and express the result as a percentage. The formula for the operating profit margin ratio is as follows:
Operating Profit Margin = Operating Profit / Total Revenue x 100%,
In the above formula, the operating profit can be found by subtracting the cost of goods sold and other expenses from the net sales. The total revenue is the total amount of money a company retains from selling its goods and services.
Why Is Operating Profit Margin Important?
Operating profit margin provides a quick overview of whether the company in question is operationally efficient or not. It gives more insight into the company’s operations as compared to other metrics, such as gross profit margin.
For example, the gross margin value only tells whether a company is making money on each unit sold after subtracting materials, labor, and other production costs. However, it does not take into account the costs associated with rent and utilities; marketing, sales, and administrative expenses; and depreciation of plant and equipment.
Looking at the operating profit margin instead reveals a more detailed picture of whether the company is creating total economic value and how efficient its operations are.
How to Calculate Operating Profit Margin
As outlined above, the formula for operating profit margin is relatively straightforward and requires only two components: operating profit and total revenue. All the information required to calculate the operating profit margin ratio can be found on the income statement or statement of operations, and the calculation itself requires only a basic understanding of financial statements.
Let’s go through the calculation process step by step:
- Find total revenue. Total revenue is how much money a company generates from its core operations, such as selling products or services. The total revenue value can be found directly on the income statement.
- Calculate gross profit. Gross profit can be calculated by subtracting the cost of goods sold (COGS) from total revenue.
- Calculate operating profit. Operating profit, or EBIT, can be calculated by subtracting the regular selling, general, and administrative (SG&A) costs from gross profit. Sometimes, EBIT is included on the income statement, but reporting it is not required by the U.S. GAAP.
- Divide operating profit by total revenue. Next, divide operating profit by total revenue to find the amount of revenue that remains with the company after accounting for the production and selling costs.
- Convert the result into a percentage. Finally, convert the ratio into a percentage by multiplying the result by 100%.
Example of Operating Profit Margin Calculation
Suppose Company ABC makes $10M in total revenue. Its SG&A expenses are $2M, and its COGS is $5M. The operating profit margin can then be calculated as follows:
Gross Profit = Total Revenue - COGS = $10M - $5M = $5M
Operating Profit = Gross Profit - SG&A = $5M - $2M = $3M
Operating Profit Margin = Operating Profit / Total Revenue x 100%
Operating Profit Margin = $3M / $5M x 100% = 30%
We have found that Company ABC has an operating profit margin of 30%, which is generally considered to be a good value.
Interpreting Operating Profit Margin
Both internal management and external stakeholders calculate the operating profit margin to evaluate the profitability of the company in question and to gauge the efficiency of its operations.
What Does Operating Profit Margin Indicate?
The value of the operating profit margin shows how much earnings from operations is generated from every 1$ in sales, after taking into account all the direct costs associated with earning these revenues.
Operating profit margin is expressed as a percentage, with larger margins corresponding to better operational efficiency. Therefore, a simplified operating profit margin interpretation is: the larger the margin, the more of every dollar in sales is kept as profit.
What Is a Good Operating Profit Margin?
Generally speaking, a 10% margin is considered average, while an operating margin of 15% or higher is considered good. However, the value of a good operating profit margin can vary depending on the industry a company operates in. For example, the average restaurant profit margin is only 3% to 6%, with margins of 15% or higher being quite rare.
In addition to evaluating the immediate value of the operating profit margin, it is also important to consider the trend or the direction it is heading in. Companies want to see their operating margins grow over time, as it signifies that they are managing their operating expenses well and continually increasing the business profitability.
Limitations of Using Operating Profit Margin
As with other types of financial analysis, evaluating operating profit margin requires extensive research to understand the underlying factors affecting the number. Simply looking at the ratio and comparing it to peer companies isn’t enough. Instead, one should conduct research and consider a variety of factors that could lead to discrepancies in operating margins between similar companies.
For example, the method of depreciation a specific company uses may lead to changes in operating profit margin. A company using a straight-line depreciation method would see a constant margin, while a company using a double-declining balance depreciation method may report lower profit margins initially, with increasing margins over time.
As a good rule of thumb, when comparing operating profit margin ratios between peers, one should hold factors like company size, industry, geography, and business model constant. In addition, it is recommended to look at other metrics as well, such as net profit margin and gross profit margin.
“As a good rule of thumb, when comparing operating profit margin ratios between peers, one should hold factors like company size, industry, geography, and business model constant.”
Comparing Operating Profit Margin with Other Metrics
Looking at several metrics when evaluating the profitability of a company can provide a more accurate picture of its financial performance. Operating profit margin is commonly used alongside gross profit margin and net profit margin. While similar, the three metrics can provide unique insights into the company’s efficiency and profitability.
Operating Profit Margin vs Gross Profit Margin
Gross margin analyzes the relationship between gross revenue and the direct cost of sales. It can be calculated as:
Gross Profit Margin = Gross Profit / Revenue x 100%,
where Gross Profit = Revenue - COGS
In a nutshell, the gross margin metric aims to evaluate how efficiently a company is producing its product. It only factors in the direct costs involved in the product production, while the operating profit margin includes other operating expenses such as SG&A.
Operating Profit Margin vs Net Profit Margin
Net profit margin is the third profit margin metric that can be found by looking at the income statement. It can be calculated by dividing net profit by total revenue and expressing it as a percentage:
Net Profit Margin = Net Profit / Revenue x 100%,
where Net Profit = Operating Profit - Interest & Taxes
Here, net profit can be calculated by subtracting interest and taxes from operating profit or EBIT, which stands for Earnings Before Interest and Taxes.
While the operating profit margin calculation only includes operating expenses, net profit margin factors in interest and taxes as well. This allows the metric to evaluate a business’s ability to manage such payments, in addition to managing its regular operating expenses. Net and operating profit margins are commonly used in conjunction to get a fuller picture of a firm’s profitability.
Without a doubt, the operating profit margin is an important profitability metric that can be used to gauge the efficiency of a company’s operations. While it does have some limitations, operating margin can provide valuable insights into a company’s management and performance, especially when used alongside gross profit and net profit margins,