How is operating margin calculated
Operating margin, also known as operating profit margin, is a key financial metric used by organizations to assess their profitability. It measures the efficiency of a company in converting its revenues into profits before accounting for interests and taxes. In simpler terms, this ratio indicates the amount of profit a company makes from each dollar of revenue generated after considering its operating expenses. For investors and industry analysts, operating margin serves as a valuable tool to compare the operational efficiency of different companies within the same industry.
To calculate the operating margin, follow these simple steps:
Step 1: Identifying Revenues
The first step in calculating the operating margin involves determining the total revenues generated by the company during a specific period, usually quarterly or annually. Revenues are commonly referred to as gross sales or simply sales. You can find this information on a company’s income statement.
Step 2: Identifying Operating Expenses
Next, you need to determine the sum of all operating expenses incurred by the business during the same period under consideration. Operating expenses include costs such as labor wages, raw materials costs, utilities, and any other day-to-day business expenses, excluding interest and taxation.
Step 3: Calculating Operating Income
Subtracting operating expenses from total revenues gives you the operating income or profit from operations (also called EBIT – Earnings before Interest and Tax). This represents how much your business has made from its regular day-to-day operations before accounting for interest and taxes.
Operating Income = Total Revenues – Operating Expenses
Step 4: Calculating Operating Margin Ratio
Finally, divide the operating income by total revenues and multiply by 100 to express it as a percentage.
Operating Margin Ratio = (Operating Income / Total Revenues) x 100
High vs. Low Operating Margin
A high operating margin often implies that a company is efficiently managing its operations by keeping costs low and generating higher profits per dollar of revenue. It indicates a well-managed and financially stable company.
Conversely, a low operating margin may indicate that a company is experiencing difficulties managing its costs. It could also suggest that the company operates in an industry with high operational expenses and stiff competition. However, it’s essential to compare operating margins among companies within the same industry as some industries inherently have lower margins than others.
In conclusion, operating margin is a critical financial ratio for businesses and investors alike. By accurately calculating and analyzing this measure, companies can identify areas of improvement in their operations to increase profitability, while investors can use it as a tool to assess an organization’s financial health before making investment decisions.