This ratio is important because it tells you how well your company’s operations contribute to its profitability. A company with a large profit margin ratio makes more money on each dollar of sales than a company with a small profit margin ratio.
Formula for Calculating Operating Profit Margin Ratio
To calculate your company’s operating profit margin ratio, divide its operating income by its net sales revenue: Operating Profit Margin = Operating Income / Net Sales Revenue In some cases, operating income goes by the name Earnings Before Income and Taxes (EBIT). Operating income or EBIT is all the income left on your income statement after subtracting operating costs and overhead, such as selling costs, administration expenses, and the cost of goods sold (COGS). You can calculate that like this: Operating Income (EBIT) = Gross Income - (Operating Expenses + Depreciation & Amortization Expenses) You’ll also need to find the net sales revenue for your business before you can determine your operating profit margin. Finding your net sales requires no calculation because the sales shown on your income statement are net sales. If that figure is unavailable, you can calculate net sales by taking the company’s gross sales and subtracting its sales returns, allowances for damaged goods, and any discounts offered.
An Example of Calculating Operating Profit Margin Ratio
Let’s say your small business has a gross income of $250,000 for the last 12-month period—that’s also your net sales revenue. The cost of goods sold and operating expenses for the same time period equals $175,000. First, we need to calculate the operating income (or EBIT), which is your gross income or net sales revenue minus your operating expenses and the cost of goods sold: $250,000 - $175,000 = $75,000 Now, we can calculate the operating profit margin ratio, which is operating income ($75,000) divided by your net sales revenue ($250,000). $75,000 / $250,000 = 0.3 Your operating profit margin ratio is 0.3, or 30%. For every $1 of sales, your company makes 30 cents of profit.
Why Is Operating Profit Margin Ratio Important?
The operating profit margin ratio is a useful indicator of your company’s financial health. It can be used to compare your company with its competitors or similar companies. For example, a company with a ratio of 8% whose competitors average more than 10% may be at more financial risk than another company with the same ratio whose competitors average 7%. Companies with high-operating profit margin ratios can generally:
Pay for their fixed costs and interest on debtSurvive economic downturnsCompete better because they can offer lower prices than the competition
The operating profit margin ratio provides a means of determining how well a company’s business model works in comparison to its competitors or across its industry. It serves as a broad indicator of a company’s efficiency.
Limitations of Operating Profit Margin Ratio
Though the operating profit margin ratio is valuable, it also has three main limitations: The operating profit margin ratio is one of the many tools that can be used to assess your company’s financial health. It is a valuable data point, but it should not be the only number used to determine whether your company is profitable and competitive over time.
