How to Determine Operating Profit Margin Ratios

Operating Profit Margin Ratio Forumla and Uses

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In business, a company's operating profit margin is a type of profitability ratio known as a margin ratio.

A company's operating profit margin ratio tells you how well the company's operations contribute to its profitability. A company with a substantial profit margin ratio makes more money on each dollar of sales than a company with a narrow profit margin.

You can find the inputs you need for calculating a company's operating profit margin on its income statement.

Formula to Calculate 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 is all the income left on the income statement after subtracting operating costs and overhead, such as selling costs, administration expenses, and the cost of goods sold (COGS):

Operating Income (EBIT) = Gross Income - (Operating Expenses + Depreciation & Amortization Expenses) 

To calculate a company's operating profit margin:

  1. Find the operating income (EBIT) by subtracting its operational expenses, allocated depreciation, and amortization amounts from gross income.
  2. Find the net sales revenue. This requires no calculation because the sales shown on the company's income statement are net sales. If that figure is unavailable, you can calculate net sales by taking the company's gross sales and subtracting its sales returns, allowances for damaged goods, and any discounts offered.
  3. Calculate the operating profit margin ratio by dividing the figure from step one (operating income) by the figure from step two (net sales).

An Example of Calculating Operating Profit Margin Ratio

A company has gross sales of $20 million. Its cost of goods sold and operating expenses equal $15.4 million.

Operating Income (EBIT) = Gross Income - (Operating Expenses + Depreciation & Amortization Expenses) 

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.

Operating Profit Margin = Operating Income / Sales Revenue

Dividing this operating income of $4.6 million by gross sales of $20 million equals an operating profit margin of .23 or 23 percent.

Why Is Operating Profit Margin Ratio Important?

The operating profit margin ratio is a useful indicator of a company's financial health. It can be used to compare a company with its competitors or similar companies. For example, 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. 

You can also compare a single company's profit margin ratio across multiple fiscal years or quarters to measure whether that business is becoming more efficient and profitable over time.

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.

The operating profit margin ratio provides a means of determining how well a company's business model works in comparison to its competitors or across its industry. It serves as a broad indicator of a company's efficiency.

Limitations of Operating Profit Margin Ratio

Though the operating profit margin ratio is valuable, it also has its limitations.

  1. It shouldn't be used as a stand-alone calculation. The ratio has value when compared to other profit margin ratios, either over time or between businesses.
  2. Using incorrect accounting data or financial statements that were prepared using inconsistent accounting standards can create false results.
  3. It does not factor in any qualitative information about a company, nor does it give any indication of the probability of future results.

The operating profit margin ratio is one of the many tools that can be used to assess a company's financial health. It is a valuable data point, but it should not be the only number used to determine whether a company is profitable and competitive over time.