What is Operating Margin Ratio, and why is it so important?
The operating margin ratio, also known as the operating profit margin, is a profitability ratio that measures what percentage of total revenues is made up by operating income. In other words, the operating margin ratio demonstrates how much revenues are left over after all the variable or operating costs have been paid. Conversely, this ratio shows what proportion of revenues is available to cover non-operating costs like interest expense.
This ratio is important to both creditors and investors because it helps show how strong and profitable a company’s operations are. For instance, a company that receives 30 percent of its revenue from its operations means that it is running its operations smoothly and this income supports the company. It also means this company depends on the income from operations. If operations start to decline, the company will have to find a new way to generate income.
Conversely, a company that only converts 3 percent of its revenue to operating income can be questionable to investors and creditors. The auto industry made a switch like this in the 1990’s. GM was making more money on financing cars than actually building and selling the cars themselves. Obviously, this did not turn out very well for them. GM is a prime example of why this ratio is important.
The operating margin formula is calculated by dividing the operating income by the net sales during a period.
Operating income, also called income from operations, is usually stated separately on the income statement before income from non-operating activities like interest and dividend income. Many times operating income is classified as earnings before interest and taxes. Operating income can be calculated by subtracting operating expenses, depreciation, and amortization from gross income or revenues.
The revenue number used in the calculation is just the total, top-line revenue or net sales for the year.
The operating profit margin ratio is a key indicator for investors and creditors to see how businesses are supporting their operations. If companies can make enough money from their operations to support the business, the company is usually considered more stable. On the other hand, if a company requires both operating and non-operating income to cover the operation expenses, it shows that the business’ operating activities are not sustainable.
A higher operating margin is more favorable compared with a lower ratio because this shows that the company is making enough money from its ongoing operations to pay for its variable costs as well as its fixed costs.
For instance, a company with an operating margin ratio of 20 percent means that for every dollar of income, only 20 cents remains after the operating expenses have been paid. This also means that only 20 cents is left over to cover the non-operating expenses.
If Christie’s Jewelry Store sells custom jewelry to celebrities all over the country. Christie reports the follow numbers on her financial statements:
|Cost of Goods Sold:||$500,000|
|Other Operating Expenses:||$25,000|
Here is how Christie would calculate her operating margin.
As you can see, Christie’s operating income is $360,000 (Net sales – all operating expenses). According to our formula, Christie’s operating margin .36. This means that 64 cents on every dollar of sales is used to pay for variable costs. Only 36 cents remains to cover all non-operating expenses or fixed costs.
It is important to compare this ratio with other companies in the same industry.