What is an 'Operating Margin'
Operating margin measures how much profit a company makes on a dollar of sales, after paying for variable costs of production such as wages and raw materials, but before paying interest or tax. It is calculated by dividing a company’s operating profit by its net sales.
BREAKING DOWN 'Operating Margin'
A company’s operating margin, also known as return on sales, is a good indicator of how well it is being managed and how risky it is. It shows the proportion of revenues that are available to cover non-operating costs like paying interest — which is why investors and lenders pay close attention to it. Highly variable operating margins are a prime indicator of business risk. By the same token, looking at a company’s past operating margins is a good way to gauge whether a big improvement in earnings is likely to last.
How to Calculate Operating Margin
To calculate a company's operating margin, divide its operating income by its net sales revenue:
Operating Profit Margin = Operating Income / Sales Revenue
Operating income is often called earnings before income and taxes (EBIT). Operating income or EBIT is the income that is left on the income statement, after all operating costs and overhead, such as selling costs, administration expenses and cost of goods sold (COGS) are subtracted:
Operating Income (EBIT) = Gross Income - (Operating Expenses + Depreciation & Amortization)
Limitations of Operating Margin
Operating margin should only be used to compare companies that operate in the same industry, and ideally have similar business models and annual sales. Companies in different industries with wildly different business models have very different operating margins. So comparing them would be meaningless.
To make it easier to compare profitability between companies and industries, many analysts use a profitability ratio which eliminates the effects of financing, accounting and tax policies: earnings before interest, taxes, depreciation and amortization (EBITDA). For example, by adding back depreciation, the operating margins of big manufacturing firms and heavy industrial companies are more comparable.
EBITDA is sometimes used as a proxy for operating cash flow, because it excludes non-cash expenses, such as depreciation. But EBITDA does not equal cash flow! That’s because it does not adjust for any increase in working capital or account for capital expenditure that is needed to support production and maintain a company’s asset base – as operating cash flow does.
Other Use for Operating Margin
Operating margin is sometimes used by managers to see which company projects are adding most to the bottom line. However, how to allocate overhead can be a complicating factor.
For more information on this topic, check out Analyzing Operating Margins.