Operating Profit Ratio

What is Operating Profit Ratio?

The operating profit ratio is the amount of money a company makes from its operations. It demonstrates the financial sustainability of a company’s basic operations prior to any financial or tax-related repercussions. As a result, it is one of the better indicators of how successfully a management team runs a company. The operational margin ratio is a measure that determines how much profit a company makes on a rupee of sales. Higher operating profit margin ratios are seen positively. Since they demonstrate a company’s effectiveness in managing its operations and capacity to convert sales into profits.

Operating Profit Ratio Formula

the formula for the operating profit margin is as follows –

Operating Profit Ratio = Operating Profit / Net Sales

Where,

• Operating Income: This income is the profit left after daily expenses and cost of goods have been deducted from net sales. It considers only those factors that are relevant to the company’s operations and excludes any irrelevant variables.
• Operating Expense: It includes salaries, wages, consultant fees, raw material costs, processing and manufacturing expenses, administrative costs, advertising and marketing costs, rent, utilities, insurance, depreciation, etc. It does not include such expenses that are not directly related to the main operation or business operations of the company. Hence, expenses such as tax, interest on loans, loss or profit from investments, etc are not included in this computation.
• Revenue or Net Sales: Revenue or net sales is the gross sales earned from the main and related income-generating activities of the company. To arrive at net sales, analysts must exclude discounts and returns from gross sales.

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How to Calculate Operating Profit Margin?

Illustration on Calculation of Operating Profit Margin is:

Particulars	Financial Year 2021-2022 Amount	Financial Year 2020-2021 Amount
Total Sales	Rs 16,00,000	Rs 15,00,000
Discounts	Rs 1,00,000	Rs 1,00,000
Sales Return	Rs 1,00,000	Rs 50,000
Operating Expense (administrative costs, advertising and marketing costs, rent, utilities, insurance)	Rs 2,00,000	Rs 1,50,000
Cost of Goods Sold	Rs 6,00,000	Rs 5,00,000
Depreciation	Rs 50,000	Rs 40,000
Net Sales (Total Sales – Discounts – Sales Return)	Rs 14,00,000 (Rs 16,00,000 – Rs 1,00,000 – Rs 1,00,000)	Rs 13,50,000 (Rs 15,00,000 – Rs 1,00,000 – Rs 50,000)
Operating Profit (Net Sales – Operating Expense – Cost of Goods Sold – Depreciation)	Rs 5,50,000 (Rs 14,00,000 – Rs 2,00,000 – Rs 6,00,000 – Rs 50,000)	Rs 6,60,000 (Rs 13,50,000 – Rs 1,50,000 – Rs 5,00,000 – Rs 40,000)
Operating Margin Ratio (Operating Profit / Net Sales)	39.29% (Rs 5,50,000 / Rs 14,00,000)	48.89% (Rs 6,60,000 / Rs 13,50,000)

Interpretation of Operating Profit Margin

A high, low or good operating margin ratio depends on the company’s past performance, the industry to which it belongs, and competitors belonging to similar industries. When a company’s operating profit ratio outperforms the industry average, it is considered to have a competitive advantage, implying that it is more successful than similar businesses. While the typical margin varies by industry, businesses can gain a competitive advantage by boosting sales or cutting expenses-or both-in general.

An operation intensive business like aviation and transportation will ideally witness a lower operating margin.

On the other hand, a service intensive industry like software development earns a higher operating margin than an aviation industry. Hence, while evaluating the operating margin of a company, it is imperative to first understand the industry trends over the years. 

The operating margin can be increased by boosting revenue or sales and by lowering expenses. The expenses comprise the cost of goods sold and other operating expenses. Hence, lowering these expenses would lead to a higher operating profit and margin. 

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Importance of Operating Profit Margin

Operating margin ratio indicates how well a company is run and how effectively it can generate profits from its sales. This ratio illustrates the extent to which revenues are accessible and can be used to meet non-operating costs such as interest payments. Because of this, investors and lenders alike pay particular attention to the operating margin measure.

Extremely fluctuating operating margins suggest business risks. Examining a company’s prior operating profit ratio is the best way to determine whether its performance has improved over time. Superior managerial controls, more efficient resource use, better pricing, and more systematic marketing can all help to improve operating margins.

The operating profit ratio shows how much profit a company makes from its principal business in relation to its total sales. Investors can use this indicator to identify whether a company earns money largely from its core operations or from other sources such as investment.

Uses of Operating Margin Ratio

Tracking the operational profit margin on a historical trend line is particularly important for identifying any long-term changes that management should be aware of. It can also be compared to the industry average and main competitors to determine whether the company’s core business is competitive. It is primarily concerned with the company’s fundamental ability to make profits.

Limitations of Operating Margin Ratio

Operating margin should only be used to compare companies that operate in the same industry. Furthermore, these businesses should ideally have similar business concepts and annual sales. Companies in different industries are likely to have vastly different business models, and their operating profit ratio are unlikely to be identical. As a result, any comparisons made between them would be meaningless.

When comparing the profitability of different organizations and industries, analysts frequently use a profitability ratio since it eliminates the impact of accounting, finance, and tax rules. EBITDA stands for earnings before interest, taxes, depreciation, and amortization.

EBITDA is sometimes used instead of operating cash flow because it does not include non-cash items like depreciation. However, EBITDA does not equal cash flow because it does not adjust for changes in working capital. EBITDA does not, like operating cash flow, take into account capital expenditures that are essential to support production and assist maintain a company’s asset base.

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