One of the key metrics used when analyzing a business’s profitability and quality of earnings is operating profit margin. While many metrics are used in conjunction with other ratios or calculations, operating profit margin is somewhat self-explanatory and can be quickly referenced. It is one of the key performance indicators that are often monitored as part of the corporate performance management (CPM) process.
In this FAQ we will discuss what operating profit margin is, why it is important, and how it is calculated.
What Is Operating Profit Margin?
Operating profit margin is the ratio of operating income to net sales. It measures profitability on a per-dollar basis, after accounting for the variable costs of production but does not include interest or tax expense. There are various ways the ratio is used but typically, a higher ratio is considered better.
The ratio is sometimes referred to as return on sales because it is the portion of revenue that remains available to cover non-operating expenses. This means it is the percentage of every dollar of sales that can be used to cover interest and tax expense.
Why Is Operating Profit Margin Important?
Operating profit margin is often used as a way to identify how well a business is being managed and how efficiently it can generate profits. Because volatile operating margins are an indicator of risks, the ratio is referred to over time to ensure that the business does not have issues maintaining sufficient margins.
The metric is a measurement of how much profit is made from the core operations of the business in relation to its total revenues. As such, it allows external parties to identify the various ways a business might be generating income.
Because it shows the percentage of revenues available to cover non-operating expenses it is also helpful to reference in the budgeting process. It is a good performance indicator to monitor the effectiveness of budgeting initiatives and cost-saving efforts. Although it cannot be exclusively relied on for monitoring expense reduction, it is a good indicator that business processes are running efficiently or that budgeting initiatives along with operating initiatives are yielding positive results.
The ratio excludes the costs of financing and therefore can be used as a way to determine how much financing, if any, can be used by the company to grow. If operating profit margin is too low, financing might not be a suitable option to expand the business and it could suggest that some other form of investment will be required to expand.
How Is Operating Profit Margin Calculated?
The formula for calculating operating profit margin is straightforward and requires only a basic understanding of financial statements to perform. All of the information needed to calculate operating profit margin is located on the income statement or statement of operations.
The formula for calculating operating profit margin is:
Operating Profit Margin=EBITTotal Revenue
EBIT refers to Earnings Before Interest and Taxes and can be calculated by taking total revenue less the cost of goods sold (COGS) and the regular selling, general, and administrative costs (SG&A). Sometimes EBIT is presented directly on the income statement, but it is not a requirement of US GAAP to directly report.
Interpreting Operating Profit Margin
Operating profit margin is expressed in terms of percentages. The higher the percentage the higher the margin. In corporate finance, the term margin can take on several meanings. In this case, operating profit margin is the amount of revenue that remains after accounting for the direct production and selling costs.
When operating margin is high, it means that the amount of operating profit generated on each dollar of revenue is high. This is a good indicator that a business has a high quality of earnings. Analysts rely on this metric to identify if a business’s core operations are efficient, and have the ability to generate net income.
If operating profit margin is low, it is an indicator that operating costs are too high, non-operating costs are too high, or both are too high. The ratio is a measurement of profitability, therefore when the resulting metric is low it is an indicator that profitability is too low.
Often, analysts will calculate operating profit margin over time as a way to gauge management’s effectiveness in reducing costs and increasing efficiencies over time. If operating profit margin trends downward and revenue remains relatively stable, it is an indicator that operations and overhead need to be addressed.
Ideally, operating profit margin will increase over time as a business becomes more efficient and manages its costs more effectively.
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