When looking at a company, it isn’t always possible to assess how well it is being managed or the efficiency with which it operates by a mere overview. Certain metrics like the operating margin are capable of providing insight into the same. Should you find yourself wondering “what is operating margin?” you have come to the right place. Continue reading to learn about it.
Operating Margin – Definition
The operating margin is a metric used to ascertain the amount of profit a company makes on a Rupee of sales following its payments made towards the variable costs of production (these include raw materials and wages) but prior to its payment of interest or tax. In order to calculate the operating margin of a company, you must divide its operating income by its sales. Ordinarily, higher operating margin ratios are viewed favourably as they showcase the company’s efficiency in managing its operations and its ability to convert sales into profits.
Examining the Scope of Operating Margin
Also referred to as the return on sales (or ROS) of a company, this metric helps indicate how well a company is being managed and the efficiency with which it is capable of generating profits from its sales. This metric makes clear the extent to which revenues are available and can be directed towards covering non-operating costs such as those associated with the payment of interest. Owing to this very fact the operating margin metric is paid close attention to by investors and lenders alike.
Operating margins that are incredibly variable indicate business risks. The best way to ascertain whether a company’s performance has improved over time is by taking a look at its previous operating margins. Operating margins are capable of being enhanced and improved upon with the aid of superior management controls, resources being used with greater efficiency, better pricing and more systematic marketing.
Simply put, the operating margin highlights the profit a company draws from its primary business with reference to its revenue in its entirety. With this metric, investors can determine whether a company is primarily generating income from its core operations or via alternative means like investing.
Calculating the Operating Margin
The operating margin can be calculated with the formula provided below.
Operating Margin = Operating Earnings / Revenue
The numerator mentioned here takes into account a company’s earnings before interest and taxes (or EBIT). These operating earnings are calculated by subtracting the cost of goods sold (i.e., COGS) along with the mainstream selling, general and administrative costs associated with running a company from the revenue. Interest and taxes aren’t included here.
Using an Example to Explain Operating Margin
In order to gain further insight into this metric consider company ABC which has the following statistics.
It reports revenue of INR 90 Lakhs.
The COGS reported by ABC amount to INR 7 Lakhs.
ABC’s administrative expenses are INR 2 Lakhs.
Its operating earnings are INR 90 Lakhs – (INR 7 Lakhs + INR 2 Lakhs) = INR 81 Lakhs
- Therefore, its operating margin amounts to INR 81 Lakhs / 90 Lakhs = 90
Limitations Associated with the Operating Margin
Operating margin should only be used to draw comparisons between companies operating in the same industry. Furthermore, these companies should ideally have business models and annual sales that are similar to one another. Companies belonging to different industries are likely to have stark differences between their business models and their operating margins aren’t likely to be the same. Comparisons that are drawn between them, therefore, would not account for much.
Analysts often employ a profitability ratio as it removes the impact that accounting, finance and tax policies might have when drawing comparisons between the profitability of different companies and industries. Earnings before interest, taxes, depreciation and amortization (or EBITDA) is relevant here.
On occasion, EBITDA may be used in lieu of operating cash flow as it doesn’t take into account non-cash expenses such as depreciation. That being said, EBITDA does not equal cash flow as it doesn’t adjust itself in the event there is an increase in the working capital. Nor does EBITDA take into account capital expenditure that is required to support production and help maintain the asset base of a company in the manner that operating cash flow does.
Alternative Profit Margins
When one compares EBIT to sales, the resultant operating profit margins helps shed light on the success with which a company’s management has been able to generate income from the company’s business operations. There exist a number of alternative margin calculations that are employed by businesses as well as analysts which help yield slightly different insights into how profitable a company is. Take for instance the gross margin which indicates the profit a company makes on its cost of sales or the net margin which helps compare a company’s net income with its sales.
The value of operating margin lies in its ability to measure the overall profitability of a company that it draws from its operations. It can be understood as a ratio of a company’s operating profits to its revenues.