How To Determine Operating Profit Margin Ratios

Operating Profit Margin Ratio Formula and Uses

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Your company's operating profit margin is the ratio you get when you divide operating income by your sales revenue. It's a type of profitability ratio known as a margin ratio.

This ratio is important because it tells you how well your company's operations contribute to its profitability. A company with a large profit margin ratio makes more money on each dollar of sales than a company with a small profit margin ratio.

Key Takeaways

• Your operating profit margin ratio shows you how profitable your company is.
• The larger the ratio, the more money your company makes on each dollar of sales.
• To calculate your company's operating profit margin ratio, divide your operating income by your net sales revenue.
• You can find the inputs you need for calculating a company's operating profit margin on its income statement.

Formula for Calculating Operating Profit Margin Ratio

To calculate your company's operating profit margin ratio, divide its operating income by its net sales revenue:

Operating Profit Margin = Operating Income / Net Sales Revenue

In some cases, operating income goes by the name Earnings Before Income and Taxes (EBIT). Operating income or EBIT is all the income left on your income statement after subtracting operating costs and overhead, such as selling costs, administration expenses, and the cost of goods sold (COGS). You can calculate that like this:

Operating Income (EBIT) = Gross Income - (Operating Expenses + Depreciation & Amortization Expenses)

You'll also need to find the net sales revenue for your business before you can determine your operating profit margin. Finding your net sales requires no calculation because the sales shown on your income statement are net sales. If that figure is unavailable, you can calculate net sales by taking the company's gross sales and subtracting its sales returns, allowances for damaged goods, and any discounts offered.

An Example of Calculating Operating Profit Margin Ratio

Let's say your small business has a gross income of \$250,000 for the last 12-month period—that's also your net sales revenue. The cost of goods sold and operating expenses for the same time period equals \$175,000. First, we need to calculate the operating income (or EBIT), which is your gross income or net sales revenue minus your operating expenses and the cost of goods sold:

\$250,000 - \$175,000 = \$75,000

Now, we can calculate the operating profit margin ratio, which is operating income (\$75,000) divided by your net sales revenue (\$250,000).

\$75,000 / \$250,000 = 0.3

Your operating profit margin ratio is 0.3, or 30%. For every \$1 of sales, your company makes 30 cents of profit.

Why Is Operating Profit Margin Ratio Important?

The operating profit margin ratio is a useful indicator of your company's financial health. It can be used to compare your company with its competitors or similar companies.

For example, a company with a ratio of 8% whose competitors average more than 10% may be at more financial risk than another company with the same ratio whose competitors average 7%.

Note

You can also compare a single company's profit margin ratio across multiple fiscal years or quarters to measure whether that business is becoming more efficient and profitable over time.

Companies with high-operating profit margin ratios can generally:

• Pay for their fixed costs and interest on debt
• Survive economic downturns
• Compete better because they can offer lower prices than the competition

The operating profit margin ratio provides a means of determining how well a company's business model works in comparison to its competitors or across its industry. It serves as a broad indicator of a company's efficiency.

Limitations of Operating Profit Margin Ratio

Though the operating profit margin ratio is valuable, it also has three main limitations:

1. It shouldn't be used as a stand-alone calculation: The ratio has value when compared to other profit margin ratios, either over time or between businesses.
2. False results can happen: Using incorrect accounting data or financial statements that were prepared using inconsistent accounting standards can create false results.
3. It's not indicative of a company's quality or future: It does not factor in any qualitative information about a company, nor does it give any indication of the probability of future results.

The operating profit margin ratio is one of the many tools that can be used to assess your company's financial health. It is a valuable data point, but it should not be the only number used to determine whether your company is profitable and competitive over time.

What does the operating profit margin ratio tell you?

The operating profit margin ratio tells you a little bit about the financial health of your company. The larger the ratio, the more profitable your company is. The smaller the ratio, the less profitable. You can use it to compare your company with others, but there are some limitations, such as not giving any indication of future profitability.

What is operating profit margin?

The operating profit margin is the ratio you get when you divide operating income by net sales revenue. If it's positive, it'll be higher than 0. If it's 0, the company is breaking even. If it's a negative number, the company operates at a loss.