The Operating Margin Ratio is a metric that results from dividing the Net Operating Income by the business’ net sales, in order to estimate the percentage of the revenues that the company earns after it has covered the cost of goods sold and all its operational expenses such as rent, payroll, utilities, depreciation and amortization.
What is the Operating Margin Ratio?
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The Operating Margin Ratio is employed to analyze how profitable a business is considering its organizational structure, marketing strategies, sales strategies and current fixed expenses. It measures its capacity to generate money from sales, after all costs and expenses related to the core operations are deducted.
This metric excludes financial expenses, as those are unrelated to operations, since they are derived from the business’ financial structure. Nevertheless, depreciation and amortization charges are commonly included as expenses since the assets that are being depreciated or amortized are essential to the company’s operational capacity.
Businesses with high ratios can be considered mature and their business model can be considered sustainable. On the other hand, business that struggle to earn money on the operational level may have to go through restructuring processes in order to improve their financial situation.
Operating Margin Ratio Formula
The formula to calculate the Operating Margin Ratio is the following:
Operating Margin Ratio = EBIT / Net Revenues
Operating Margin Equation Components
EBIT: Earnings before Interest & Taxes
Net Revenues: The total sales brought in by the business minus all discounts, markdowns and any other item that may reduce the total sales.
The result of the formula is a percentage and it can be interpreted as the percentage of sales that the business retains after it pays for all its costs and operational expenses.
Operating Margin Example
Wanna Surf LLC is a company that has stores in several coastal cities of the U.S., where they offer surf lessons and entire courses for people who want to learn this sport. Currently, the CEO of the company received the latest annual report where it appears the company’s net income wasn’t as high as expected.
One of the things he first saw was the Operating Margin Ratio, which was 12%. The company’s annual report breaks down the expenses as follows:
- Sales: $7,860,000
- COGS: ($3,340,000)
- Gross Profit: $4,520,000
- Gross Margin Ratio: 57.50%
- Marketing Expenses: $927,100
- Sales Expenses: $123,000
- Administrative Expenses: $657,000
- Rent: $1,556,000
- Utilities: $46,700
- Depreciation & Amortization: $267,000
Earnings before Interest & Taxes (EBIT): $943,200
The Operating Margin Ratio in this case can be easily calculated as follows:
Operating Margin Ratio = ($943,200 / $7,860,000) = 12%
Even though rent appears to be the highest expenses, the company has privileged front-beach locations that they can’t give up since they drive most of the traffic the stores need to sell as much as they do.
Nevertheless, the CEO did identify that administrative expenses could be cut by half to increase operating margins by 4%, along with perhaps decreasing the marketing expenses, as the company is well known now and they don’t have to be that aggressive to get new clients.
Operating Margin Ratio Analysis
The Operating Margin Ratio is a popular metric, since it delivers a clear picture on any business’ earning power. It also tells a lot about the company’s management, as a low operating margin ratio means that expenses are not under control, that sales are not high enough to cover for those expenses or even that the business model is not really well conceived.
On the other hand, the Operating Margin Ratio is also a great metric to compare similar companies. A company that has a substantially lower ratio than its peers may not be properly organized and it can be a perfect candidate for a restructuring process. On the other hand, a company with a substantially higher operating margin than its competitors can be considered a highly efficient venture with the capacity to become the market leader.
Alternatively, a company with a low operating margin ratio has to be deeply analyzed to understand the reason why the ratio is low. It could be that the marketing expenses are too high and not producing a return on investment high enough to produce more business, or it could also be that the company’s organizational structure is too expensive. The cost of renting and also legal fees may affect operational profits if they are not properly managed.
Finally, operating margin ratios can be compared between different years. A declining trend may indicate that the company’s business model is currently struggling to produce profits and if the trend is not reserved it will eventually lead to a financial loss. On the other hand, an upward trend may indicate that the business has improved its internal structure and processes in a way that is earning more money out of its sales. It could also mean that the business is stepping into economies of scale.
Analyzing each expense account individually may help managers in identifying the source of the issue. In the example above, the CEO of Wanna Surf could identify that by cutting administrative expenses and marketing expenses he could boost profits significantly.
Operating Margin Uses, Cautions, Pitfalls
While the Operating Margin Ratio can quickly tell the history of a company’s profitability and earning power, it could also be misleading if the information is not compared with that of similar businesses. For example, certain industries are comfortable with operating with low margins, given that the volume of business they produce is large enough to produce high returns, even though operating margins are low. If the business is not one that requires extensive capital to operate, the operating profit, even though small, may suffice to provide high returns.
On the other hand, a low Operating Margin Ratio may not only be caused due to high expenses. It could also be just the result of low gross margins, coming from poor relationships with suppliers or a product line that is not profitable enough.
In any case, in order to analyze the Operating Margin ratio results properly, many elements have to be individually evaluated to understand why the end result looks like that.