How to Determine Operating Profit Margin Ratios
Operating profit margin is a type of profitability ratio known as a margin ratio. The information with which you can calculate the operating profit margin for a business can be found on that company's income statement.
A company's operating profit margin ratio tells you how well a 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.
This article describes how the profit margin ratio is calculated and assesses the calculation's value.
How to Calculate 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
Operating income is often called earnings before income and taxes (EBIT). Operating income or EBIT is the income that is left on the income statement, after all, operating costs and overhead, such as selling costs, administration expenses and cost of goods sold (COGS) are subtracted out:
Operating Income (EBIT) = Gross Income - (Operating Expenses + Depreciation & Amortization)
To calculate a company's operating profit margin, you must first calculate its operating income.
To do this, follow these steps:
- Find the company's operating income by subtracting from its gross income its operational expenses and its allocated depreciation and amortization amounts.
- Find the company's net sales revenue. It 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 Operating Profit Margin Ratio Determination
To see this calculation in practice, let's review an example. A company has a gross income of $20 million. Its cost of goods sold are $15 million. It also has $400,000 in depreciation. Therefore, its operating income equals $20 million gross income minus $15 million COGS minus $400,000 in depreciation, which is $4,600,000.
The same company's gross sales are $30 million. Missing or damaged goods equal $1 million. Discounts offered total $700,000. Therefore, its net sales equal $30 million gross sales minus $1 million minus $700,000, which is $28,300,000
Dividing this company's operating income of $4,600,000 by its net sales of $28,300,000 equals 16.25254417 or 16.25 percent, the operating profit margin.
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
- can be more competitive by offering lower prices than competing companies with lower profit margin ratios are unable to match
The operating profit margin ratio provides a means of determining how well a company's business model works in comparison to its competitors. It is a broad, but useful indicator of a company's efficiency.