Ratio analysis is an essential part of studying financial statements to form an understanding of a business. The wide range of ratios used in financial analysis covers the profitability, valuation, solvency, and leverage of a concerned organisation. Of the numerous ratios, operating margin is a prominent one when we want to know about how profitable a business is.
Also known as the operating profit ratio, it defines the relationship between a company’s operating profits and net sales in an accounting period. It is often used interchangeably with operating profits, which is an inaccurate representation of this ratio.
Operating margin is one of the key measures of a company’s profitability. It is denoted in terms of percentage and represents the amount of operating profit a company can generate against Re.1 of its sales.
For instance, if the operating margin of a hypothetical company is 25%, then it goes on to show that such a company is making Rs.0.25 as operating profits against Re.1 of total revenue.
All operational costs directly and indirectly related to business operations are deducted from net sales in the calculation of operating margin.
Therefore, it shows the proportion of revenue an organisation could divert to non-operational expenses, address liabilities, finance growth, pay dividends to shareholders, and hold reserves.
Ergo, an operating margin is a critical indicator of the efficiency of a company’s core business operations and also managerial competency. Some financial experts also utilise it to infer the risk associated with an organisation.
As mentioned previously, an operating margin represents operating profits in relation to total revenue. Therefore, for operating margin calculation, one must firstly deduct expenses like Cost of Goods Sold (manufacturing overheads), administrative overheads, and depreciation & amortisation from the net sales to compute the operating profit.
Operating profit can be expressed as:
Operating profit = Net sales – (COGS + Administrative overheads + Depreciation and Amortisation)
It can also be written as,
Operating profit = Gross profit – (Administrative overheads + Depreciation & Amortisation) [Since, Gross profit = Net sales – COGS]
Here, the Net sales amount is derived from gross sales by netting it against discounts, returns, and allowances.
The cost of goods sold includes all expenses directly associated with revenue-generating activities. That incorporates –
Administrative overheads, on the other hand, include all expenses that are crucial for day-to-day operations but have no direct bearing on revenue-generating activities. It involves –
Example: An excerpt from the Income Statement of Procter and Gamble as of June 30th, 2019 is presented below.
| Particulars | Amount ($ in millions) |
| Net sales | 67,684 |
| Cost of products sold | 34,768 |
| Selling, general, and administrative expenses | 19,084 |
| Goodwill and indefinite-lived tangible asset impairment charges | 8345 |
| Interest expense | 509 |
| Interest income | 220 |
| Other non-operating net income | 871 |
In the calculation of operating profit, any expense or income that does not stem from operational activities is not considered. Therefore, in the calculation of the operating profit of P&G, only these items shall be included – net sales, cost of products sold, selling, general, administrative expenses, goodwill, and indefinite-lived tangible asset impairment charges.
Ergo, Operating Profit of P&G = $ {67,684 – (34,768 + 19,084 + 8345)} million = $5,487 million
Post the calculation of operating profit it shall be divided by total revenue or net sales to derive the operating profit.
The formula is mentioned below:
Operating Margin = Operating Profit / Net Sales
It could also be expressed as, (Net sales – Operating expenses) / Net sales
Let’s consider the above instance of Procter & Gamble as an operating margin ratio example. In the statement, its total income from sales stood at $67,684 million from July 2018 – June 2019. Its operating expenses, for the same period, come about to be $ (34768 + 19084 + 8345) million or $62,197 million.
Therefore, Operating profit ratio of P&G for the year that ended on June 30th 2019 = (67,684 – 62,197) / 67684 = 0.081 or 8.1%
As mentioned previously, this ratio is a critical indicator of a company’s financial health, managerial competency, efficiency in core business operations, and associated risk. Therefore, it is of paramount value to investors, shareholders, and creditors.
A positive operating margin value is far more desirable to both a company’s internal and external factors than otherwise.
On that note, a high operating margin indicates an efficient and substantially profitable core operational setup. Conversely, a low ratio implies an inferior and less profitable operational setup.
Furthermore, the measurement of how much revenue a company can manage to translate into operating profit highlights the managerial competency of such an organization. A high operating margin means more funds to meet non-operating costs like interest, taxes, etc. That is of particular interest to creditors and investors since it directly correlates to the risk associated with an organisation.
The operating profit ratio also facilitates comparison between companies belonging to the same industry. That is because the margin of operating expenses varies from one industry to another. Some industries might be labor-intensive and therefore, incur higher operational expenses when compared to capital-intensive industries.
The operating margin ratio can also reveal a thing or two about the financial health of the company in question. For that purpose, analysts should study the ratio across different periods.
If the operating margin of a company increases steadily over accounting periods, it implies stable and improving financial health. That is a green signal for investors and creditors.
Conversely, if the operating profit ratio of a company is erratic or decreases over a period of time, it may be indicative of an underlying problem in the financial health of a company, and hence raises a red flag for both investors and creditors.
In other words, the ratio portrays how a company is spending its monetary resources to generate Re.1 of revenue and whether such efficiency is improving or degrading over time.
However, organisations can utilise this ratio in their favour to keep a check on their performance and make necessary arrangements to get back on track.
As mentioned previously, the operating margin can be applied to comparisons between companies that belong to similar industries.
To make up for these shortcomings, analysts use Earnings before Interest, Taxes, Depreciation, and Amortisation (EBITDA). EBITDA does away with the impacts of taxation, financing, and accounting policies that make comparison with an operating margin less effective.
One merely needs to add back depreciation and amortisation costs to operating profit to reach EBITDA.
Gross margin is the ratio between the cost of goods sold and net sales. Therefore, the primary distinction between operating profit ratio and gross profit ratio is that the latter does not account for administrative overheads and depreciation & amortisation.
Therefore, gross margin provides an understanding of a company’s cost-effectiveness in the production of goods or provides services. It is, therefore, a key indicator of soundness adopted in a company’s revenue-generating activities.
Net margin is the ratio between net profit and net sales. Operating profit minus interest and taxes equates to net profit.
Analysing operating margin in relation to net margin allows a significant understanding of a company’s leverage.
If the former substantially differs from the latter, it indicates that such a company is functioning on high leverage. It means most of a company’s operating profit is chipped away by interest payment. Therefore, it indicates an unsound borrowing policy.
A good operating margin varies based on industry, market capitalisation, and business model.
EBITDA is more useful than operating, in comparisons between companies from different industries. It helps to understand a company’s profit sans tax implications, accounting policies, and financing.
Tax is not included in the calculation of operating profit since it is not an operating expense.