Operating profit margin is a ratio that measures the profitability of a business. It measures how much a business makes in revenue after paying for operating and non-operating expenses.
In other words, operating profit margin indicates how much of the profits are left after paying business expenses.
Why operating profit margin matters
Operating profit margin is a useful indicator of a company’s financial health. You can also use it to compare a business with similar companies in an industry or to its competitors.
When a business has higher margins, there’s typically less financial risk. As an investor, it’s helpful to calculate operating profit margin across multiple quarters or fiscal years so you can see whether the business is becoming more (or less) profitable over time. Companies with higher operating profit margins are usually:
- Able to cover fixed costs as well as debt payments.
- Strong enough to survive economic downturns.
- More competitive.
While operating profit margin is a useful metric to determine if a business is profitable, it does have limitations. Operating profit margin won’t tell you:
- About a business’s restructuring or income tax expenses.
- A business’s economic value or cash flow. Ultimately, cash flow is the best predictor of a business’s value.
- A company’s growth rate. Fast-growing companies will often start with negative operating profit margins because they’re more aggressive with expenses. On the other hand, low-growth businesses are more mature, but they might have higher operating profit margins. As an investor, it’s important to understand a business’s growth prospects to determine its potential.
Operating profit margin should be one piece of the puzzle for determining a business’s value. Don’t rely on any one factor to determine the value of a business or an investment; it’s always best to take a holistic view of an opportunity before investing.
How to calculate operating profit margin
You can easily calculate operating profit margin if you know a business’s:
- Operating income: Operating income is also called “earnings before income and taxes” or EBIT. You can calculate EBIT by taking a business’s gross income and subtracting expenses, depreciation, and amortization.
- Revenue: This is the income the business generates. It’s also called gross income and doesn’t account for expenses.
You can use this formula to understand a business’s operating profit margin and its profitability:
Operating profit margin = operating income / revenue X 100
Basically, operating profit margin calculates the income that’s left after subtracting all of a business’s operating costs and overheads, expressed as a percentage.
For example, say Company A makes $10M in revenue. Its cost of goods sold (COGS) is $5 million and its selling and general administrative (SG&A) expenses are $2M.
First, you need to figure out the business’s gross profit:
$10M (revenue) - $5M (COGS) = $5M in gross profit
Next, you need to determine the business’s operating income:
$5M (gross profit) - $2M (SG&A) = $3M in operating income.
Now you can plug these two numbers into the operating profit margin formula to find its profit margin:
$3M (operating income) / $10M (revenue) = 0.3 X 100 = 30% operating profit margin
The higher the profit margins, the more profitable the business is.
