How to Determine Operating Profit Margin Ratios
A company's operating profit margin ratio tells you how well the company's operations contribute to its profitability. For instance, a company with a substantial profit margin ratio makes more money on each dollar of sales than a company with a narrow profit margin. Read on to see how to calculate the profit margin ratio and assesses the calculation's value.
Calculating the Operating Profit Margin Ratio
To calculate a company's operating profit margin ratio, divide its operating income by its net sales revenue:
Operating Profit Margin = Operating Income / Sales Revenue
In some cases, operating income goes by the name Earnings Before Income and Taxes (EBIT). Operating income or EBIT equates to the income left on the income statement, after subtracting out all operating costs and overhead, such as selling costs, administration expenses, and cost of goods sold (COGS):
Operating Income (EBIT) = Gross Income - (Operating Expenses + Depreciation & Amortization Expenses)
Calculate a company's operating profit margin using the following steps:
- Find the company's operating income (EBIT) by subtracting its operational expenses, allocated depreciation, and amortization amounts from gross income.
- Find the company's net sales revenue. This requires no calculation because the sales shown on the company's income statement are net sales. If for any reason, that figure is unavailable, you can calculate net sales by subtracting from the company's gross sales its sales returns, allowances for damaged goods, and any sales discounts offered.
- Find the company's operating profit margin ratio by dividing operating income by net sales.
An Example of the Ratio Calculation
Say that a company has gross sales of $20 million, and cost of goods sold plus operating expenses of $15.4 million. Therefore, its operating income would equal $20 million gross income minus $15.4 million in total expenses, which leaves a result of $4.6 million in operating income.
Dividing this company's operating income of $4.6 million by its net sales of $20 million equals an operating profit margin of .23 or 23 percent.
The Significance of the Operating Profit Margin Ratio
The operating profit margin ratio is a useful indicator of a company's financial health. To interpret a company's profit margin ratio in a useful way, however, you need to compare it with other similar companies.
A company with a ratio of 8 percent whose competitors average more than 10 percent may be at more financial risk than another company with the same ratio whose competitors average 7 percent. Nevertheless, companies with high operating profit margin ratios are generally:
- Better able to pay for their fixed costs and interest on debt
- Better able to survive economic downturns
- More competitive because they can offer lower prices than the competition because of their higher profit margin ratio
The operating profit margin ratio provides a means of determining how well a company's business model works in comparison to its competitors. It serves as a broad, but useful indicator of a company's efficiency.
Limitations of the Ratio
The operating profit margin ratio suffers from the same issue as many ratios, in that it doesn't provide much value as a stand-alone calculation. The ratio takes on meaning when it's compared to the same ratio from previous time periods so that it can tell you if the company's improving or not.
Additionally, you can learn how a company does against its competitors and within its industry by comparing operating margin ratios across similar companies and the industry average.
Another limitation of the ratio is the false result that you might get by using incorrect accounting data or financial statements that were prepared using inconsistent accounting standards.
The operating margin ratio also does not factor in any qualitative information about a company, nor does it give any indication of the probability of future results.