What is Operating Margin?

What is Operating Margin?

Operating margin is equal to operating income divided by revenue.  Operating margin is a profitability ratio measuring revenue after covering operating and non-operating expenses of a business.  Also referred to as return on sales, the operating income indicates how much of the generated sales is left when all operating expenses are paid off.

In the above example, you can clearly see how to arrive at the 2018 operating margin for this company.  2018 starts with Revenue of $5 million, less COGS of $3.25 million, resulting in Gross Profit of $1.75 million.

From there, another $1.3 million of Selling General & Administrative SG&A expenses are deducted, to arrive at Operating Income of $437,500.

By taking $437,500 and dividing it by $5.0 million you arrive at the operating margin of 8.8%.

Understanding the Operating Margin

A company’s operating margin, sometimes referred to as return on sales (ROS), is a good indicator of how well it is being managed and how efficient it is at generating profits from sales. It shows the proportion of revenues that are available to cover non-operating costs, such as paying interest, which is why investors and lenders pay close attention to it.

Highly variable operating margins are a prime indicator of business risk. By the same token, looking at a company’s past operating margins is a good way to gauge whether a company’s performance has been getting better. The operating margin can improve through better management controls, more efficient use of resources, improved pricing, and more effective marketing.

In its essence, the operating margin is how much profit a company makes from its core business in relation to its total revenues. This allows investors to see if a company is generating income primarily from its core operations or from other means, such as investing.

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What is the formula for Operating margin?

Operating Margin = Operating Income / Revenue  X 100

Another example:

DT Clinton Manufacturing company reported on its 2015 annual income statement a total of $125 million in sales revenue. Operating income before tax netted to $45 million after deducting all $80 million in operating expenses for the year. As a result, an operating margin of 36% was generated, or in other words for every dollar in sales achieved, $0.36 cents is retained as operating profit.

How to Use Operating Profit Margin?

Operating Profit Margin differs from Net Profit Margin as a measure of a company’s ability to be profitable. The difference is that the former is based solely on its operations by excluding the financing cost of interest payments and taxes.

An example of how this profit metric can be used is the situation of an acquirer considering a leveraged buyout. When the acquirer is analyzing the target company, they would be looking at potential improvements that they can bring into the operations.

The operating profit margin provides an insight into how well the target company performs in comparison to its peers, in particular, how efficiently a company manages its expenses so as to maximize profitability. The omission of interest and taxes is helpful because a leveraged buyout would inject a company with completely new debt, which would then make historical interest expense irrelevant.

A company’s operating profit margin is indicative of how well it is managed because operating expenses such as salaries, rent, and equipment leases are variable costs rather than fixed expenses. A company may have little control over direct production costs, such as the cost of raw materials required to produce the company’s products.

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However, the company’s management has a great deal of discretion in areas such as how much they choose to spend on office rent, equipment, and staffing. Therefore, a company’s operating profit margin is usually seen as a superior indicator of the strength of a company’s management team, as compared to gross or net profit margin.

Limitations of the Operating Margin

The operating margin should only be used to compare companies that operate in the same industry and, ideally, have similar business models and annual sales. Companies in different industries with wildly different business models have very different operating margins, so comparing them would be meaningless. It would not be an apples-to-apples comparison.

To make it easier to compare profitability between companies and industries, many analysts use a profitability ratio that eliminates the effects of financing, accounting, and tax policies: earnings before interest, taxes, depreciation, and amortization (EBITDA). For example, by adding back depreciation, the operating margins of big manufacturing firms and heavy industrial companies are more comparable.

EBITDA is sometimes used as a proxy for operating cash flow because it excludes non-cash expenses, such as depreciation. However, EBITDA does not equal cash flow. This is because it does not adjust for any increase in working capital or account for capital expenditure that is needed to support production and maintain a company’s asset base—as operating cash flow does.

Why Is Operating Margin Important?

The operating margin is an important measure of a company’s overall profitability from operations. It is the ratio of operating profits to revenues for a company or business segment.

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Expressed as a percentage, the operating margin shows how much earnings from operations is generated from every $1 in sales after accounting for the direct costs involved in earning those revenues. Larger margins mean that more of every dollar in sales is kept as profit.