The operating margin ratio is a profitability ratio that indicates how much profit a company makes from its operations before taxes and interest are deducted.
Operating margin ratios vary among the industries. They are usually used as a bench-marking tool when comparing different companies belong to a single sector. It can determine top industry performers. Also, it shows whether more research is needed to know why a certain company outperforming.
Other terms are used to refer to the operating margin ratio. These include operating income margin, return on sales (ROS) and operating margin ratio.
Operating Margin Ratio Formula
$$Operating\: Margin\: Ratio = \dfrac{Operating\: Profit}{Net\: Sales}$$
Operating profit is obtained by adding up the cost of goods sold (COGS), depreciation and amortization, and all other operating costs. These would include expenses not directly related to production, such as rent, utilities, etc.) and subtracting the sum from total revenues.
Often, you can use earnings before interest and taxes (EBIT) as the operating profit.
This formula calculates the operating profit percentage from the company’s overall earnings. For instance, an operating margin ratio of 25% is equivalent to a to $0.25 operating profit for each $1 made from the investment.
The operating margin ratio of a company also shows how its operating expenses (rent, leases, etc.) are handled. Companies may find it hard to control direct production costs, such as prices of raw materials and equipment. But they have almost total discretion over their costs.
This includes choosing an office space to rent, hiring people, and so on. In other words, the operating margin ratio is often viewed as a more reliable indicator of a company’s management’s capabilities than gross or net profit margin.
As with any financial ratio, the operating margin ratio also comes with limitations. A company interested in an outsourcing strategy, for example, can report a profit margin that is not necessarily accurate. Using false accounting figures or financial statements based on poor or inconsistent accounting standards can lead to misleading results. This can even pose a serious risk as management could end up making the wrong decisions simply because they had the wrong set of information to begin with.
When comparing different companies, the depreciation method used may also cause changes in the Operating Margin Ratio. One one hand, a company employing the double-declining balance depreciation method may report lower profit margins that increase after a while, with or without adjustments in efficiency. On the other hand, a company using the straight-line method may observe a consistent margin even if considerable changes had been made.
Operating Margin Ratio Example
Chicc ships custom furniture throughout the country. The company has the following figures in the prior year:
- Cost of goods sold (COGS): $1,000,000
- Total revenue: $3,000,000
- Rent: $30,000
- Wages: $200,000
- Other operating expenses: $50,000
Based on these values, the furniture maker’s operating profit can be calculated at $720,000. What is Chicc’ s operating margin ratio?
Let’s break it down to identify the meaning and value of the different variables in this problem.
- Operating Profit: $720,000
- Total Revenue: $3,000,000
We can apply the values to our variables and calculate the operating margin ratio:
$$Operating\: Margin\: Ratio = \dfrac{726{.}000}{3{,}000{,}000} = 0.24$$
In this case, Chicc would have an operating margin ratio of 0.24.
This indicates that 76 cents of each dollar of revenue are used to cover variable costs, while all other non-operating or fixed costs are paid with the 24 cents left. To be truly useful, a company’s operating margin ratio should be compared with those of other companies in the same sector.
Operating Margin Ratio Analysis
The operating margin ratio and net profit margin are both profitability ratios. But they are unique in that the former exclusively considers operations in the calculation, while the latter includes interest payments and taxes.
Let’s say an acquirer planning a leveraged buyout is examining the target company, particularly the possible benefits it can contribute to the operations. The exclusion of interest and taxes makes sense, considering a leveraged buyout means totally new debt, making old interest expense immaterial. The operating margin ratio sheds light on the company ‘s performance compared to that of its peers. This is especially true in terms of cost management as a way to boost profitability.
Needless to say, this metric is valuable to creditors and investors as it helps establish a company’s operations’ strength and profitability. For example, if a company gets 30% of its earnings from its operations, that means management has been effective in running its operations and the income is more than enough to keep the company going. It shows as well that the company relies on its operations’ earnings. Should operations go on a downtrend, the company will have to look for ways to earn revenues.
In contrast, a company that takes a mere 3 % of its earnings from its operating income may not be solid enough for creditors and investors. Some three decades ago, General Motors (GM) was earning more profit financing vehicles than actually manufacturing them. This soon proved to be a bad idea. It was clearly a bad idea for the automotive giant, but they have since become a classic example of why this metric is very important.
Additionally, the operating margin ratio does not consider any qualitative information on the company being assessed, nor does it offer any signs of potential future results being likely or unlikely to happen.
Generally speaking, factors like geography, industry, and business model should be held constant when comparing peer companies based on their operating margin ratios. Using other profitability ratios like gross or net profit margin is also helpful, along with other financial ratios like efficiency and market value.
Operating Margin Ratio Conclusion
- The operating margin ratio is a profitability ratio that speaks of a company’s profits from its operations before taxes and interest expenses are deducted.
- This formula requires two variables: operating profit and total revenue.
- The operating margin ratio is usually expressed as a plain decimal number.
- The operating margin ratio is not helpful for companies that have more intangible assets than fixed assets.
Operating Margin Ratio Calculator
You can use the operating margin ratio calculator below to quickly determine a company’s profits from its operations before taxes and interest, by entering the required numbers.