What is Operating Profit Margin?
As part of profitability ratios, apart from the Gross Profit margin, another important ratio is the Operating Profit Margin.
These ratios help in understanding if the company is making sufficient profit from its operations.
In this resource, let us understand about Operating Profit Margin in detail.
Operating Profit Margin meaning
The Operating Profit Margin indicates the amount of Operating Profit that the company makes on each dollar of sales. It is often considered as a core profitability metric.
Operating profit is the profit that the company makes before paying interest expense and taxes.
Hence, it is also called as Earnings before Interest and Taxes (EBIT).
Operating Profit Margin formula
The formula for Operating Profit Margin is similar to other profitability ratios.
We take Operating profit in the numerator and Net sales in the denominator.
Both values can be obtained from the Income statement.
Let us understand the formula for Operating Profit.
Operating Profit = Net Sales – Operating expenses
We reduce operating expenses from Net Sales to arrive at operating profit.
But, what are operating expenses?
Operating expenses are the core expenses that the company incurs as part of its operations.
Raw material cost, Salary & Wages, Other direct expenses related to operations will be part of operating expenses.
Apart from above, Interest expense and tax expenses are also incurred by the company.
But these expenses are not called as operating expenses.
Net Sales refers to normal revenue that the company generates from its core operations.
We need to consider both, cash sales and credit sales.
Any goods returned from the customer have to be reduced. Hence, Net sales have to be considered.
Sales value should not include any tax amount collected from customers. Hence, sales value should be net of any taxes
Let us understand the Operating margin with a hypothetical example.
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Operating Profit Margin example
Let us look at our 1st example.
We take Company A and Company B for calculating OP margin
Values given in the examples below are in $ millions.
Consider the below-given income statement for both the companies.
To calculate the Operating margin, we need
- Net Sales
- Operating Profit
Let us calculate Net Sales for both the companies
- Cash Sales= $2,000
- Credit Sales= $200
- Total Net Sales= $2,200
- Cash Sales= $2,700
- Credit Sales= $300
- Total Net Sales= $3,000
Let us Operating expenses for both the companies
- Cost of Sales = $1,000
- Other expenses = $400
- Depreciation & amortization = $600
- Operating expenses= $2,000
- Cost of Sales = $1,500
- Other expenses = $500
- Depreciation & amortization = $200
- Operating expenses= $2,200
Now, we can calculate Operating Profit
Operating Profit = Net Sales – Operating expenses
= $2,200 – $2,000 = $200
Operating Profit = Net Sales – Operating expenses
= $3,000 – $2,200 = $800
Now that we know all the values, let us calculate the margin for both the companies.
Operating Margin = Operating Profit / Net Sales
- Company A = $200/ $2,200 = 9%
- Company B = $800/ $3,000 = 27%
What this means is that Company A makes only 9% Operating Profit on each dollar of sales.
But, Company B makes almost 3 times of Company A i.e, 27%. Hence, Company B makes 27% Operating Profit on each dollar of sales.
As already highlighted, Operating Profit is that profit which helps in paying off Interest and Taxes of the companies.
As evident in the above example, Company A is unable to meet its Interest expenses with the Operating Profit it earned.
Hence, after paying off Interest expenses, company is left with negative earnings before tax (EBT) of $-200.
This is not a good indication on a standalone basis and even when compared with Company B.
Hence, it is important to earn sufficient Operating Profits so that other interest expenses and taxes can be paid off.
Industry Example – Walmart
In our next example, let us calculate the profit margin Walmart using excel.
You can download the Operating Profit Margin template for Walmart using the below option.
Below shown is the Consolidated Income Statement of Walmart.
As already highlighted, Operating Profit is also referred to as Earnings before Interest and Taxes (EBIT).
To calculate EBIT in the case of Walmart, we reduce all expenses, except Interest and Taxes.
Operating profit =Net Sales – Operating expenses
= $514,405 – ($385,301+ $96,469+ $10,678) = $21,957
Net Sales Revenue = $514,405
Now that we know all the values, let us calculate Operating Profit Margin ratio for Walmart.
Operating margin = Operating Profit/ Revenue
= ($21,957 / $514,405 ) * 100 = 4.3%
As evident, Walmart earns moderate margin of only 4.3%, which is considered as low.
What this means is that Walmart generates only 4.% of Operating Profit on each dollar of sales.
It is left out with only $21,957 to pay off its Interest expenses and Taxes.
How to Interpret the ratio?
- As we have already understood, OP margin indicates how much Operating Profit does the company make from each dollar of sales.
- Generally, high Operating Profit Margin indicates that either the company is selling the goods or services at a very high price or it is controlling its operating expenses more efficiently.
- Low Operating Profit Margin is generally because of high Operating expenses.
- Companies with limited pricing power and operating in a highly competitive environment suffer lower Operating Profits. Hence lower Profit margin.
Any financial ratios will not give a clear picture when analyzed on a stand-alone basis.
Hence trend analysis has to be performed for a particular ratio.
As you can see from the graph, the Gross Profit margin for Microsoft has been stagnant at around 60% for the past 5 years.
But, when we come to the Operating Profit Margin, we can see continuous improvement.
The Operating Profit Margin for the year 2015 was only 20%.
But, subsequently, the company was able to manage its operating expenses more efficiently and it could increase its overall Operating margin significantly.
This increased Operating Profits helps the company in paying off its interest expenses and taxes more easily.
Hence, analyzing any ratio using trend gives us a more clear picture then when analyzed on a standalone basis.
Comparison with similar companies
It is also important to track the Operating margin of various companies in different sectors.
This helps in understanding the dynamics of a particular industry.
Walmart vs Home Depot
The operating margin in the case of Walmart has been decreasing for the past 5 years which is not a good indication.
Currently, the Operating Profit Margin for Walmart is 4%
Although, not a direct comparable, but, when you compare Home Depot to Walmart, we can clearly see that the company is able to earn higher operating profits.
Also, the Profit margin for Home Depot has been increasing for the past 5 years.
Currently, the Operating Profit Margin for Home Depot is 15%
In the case of Amazon, we can see a great turnaround in operating profits.
The company was making losses at the operating profit level before 5 years.
But, gradually the company was able to turn around its profitability.
Currently, the Operating Profit Margin for Amazon is 5%
Such an increase in Operating margin from 0% to current 5% is a clear indication that the company is managing its operating expenses in the most efficient manner
In the case of a US-based multinational oil and gas company, ExxonMobil we can see fluctuation in the profit margin.
Back in 2014, the margin was as high as 9% and then subsequently it fell to almost 1% in 2016.
It is important to note that 2016 was an unusual year because of which company reported a negative operating profit.
Subsequently, the company was able to increase its operating profits and currently, the Operating Profit Margin for Exxon Mobil is 7%.
Facebook vs Google vs Microsoft
When you calculate Operating Profit Margin ratio for tech-based companies like Apple, Facebook, Google ( Alphabet) and Microsoft, you will observe that the ratios are in higher range of 20%-50%
The Operating margin in the case of Apple has been disappointing for the past 5 years.
The margin, back in 2014, was as high as 30%. But, subsequently, there has been a decrease in the margin and currently, the Operating Profit Margin for Apple is 25%.
The higher operating expenses compared to its sales is stopping the company from increasing its margins.
Compared to other tech-based companies, Facebook tends to enjoy a higher Operating margin.
Although the Gross Profit margin for Facebook was as high as 80%, gradually as we move down, we can see that the Operating margin in the range of 40% to 50%.
Barring a few fluctuations, the company is able to sustain higher profitability.
Currently, the Operating Profit Margin for Facebook is 45%. This indicates that the company has significant amount of Operating Profits to pay off its interest expenses and taxes.
As already discussed as part of Trend Analysis, Microsoft was able to increase its Operating margin significantly.
Back in 2014, the margin was as low as 20% and subsequently, the company was able to manage its operating expenses in the most efficient manner.
Hence, the ratio increased significantly.
Currently, the Operating Profit Margin for Microsoft is 34 %
The margin profile for Google is not so encouraging.
The company is not able to increase its margin for the past 5 years. Instead, it is decreasing.
Currently, the Operating Profit Margin for Google is 20%.
Below are few important aspects one must consider while analyzing any company using gross profit margin ratio
EBIT or Operating Profit:
As already highlighted, while calculating Operating Profits, Interest expenses and Taxes should not be reduced from Net Sales.
Adjusted Operating Profits:
If the company reports any non-recurring or unusual operating expenses, Analysts generally adjust such items and calculate Adjusted Operating Profits or Adjusted Operating margin.
Hence, it is important to make note of such non-recurring or unusual items.
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