In this series of articles, I will explore various financial ratios and metrics used for the analysis of financial statements. These ratios can be used for comparison amongst companies within the same sector to see which company is doing well or poorly. The ratios can also be compared across time to check whether a company is seeing an improvement or a decline in its fortunes.
My previous article is the first in the series, and I discussed the gross profit margin and how it can be used to assess whether a company has pricing power. In this article, the second in the series, let’s take a look at an equally important ratio: The operating profit margin. Note that this is also sometimes referred to as the EBIT margin, where EBIT stands for earnings before interest and taxation.
The operating profit margin is defined by Investopedia as follows:
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.
The formula would be written as such:
Gross Profit – Operating Expenses = Operating Profit
Operating Profit Margin = Operating Profit / Revenue
The operating profit margin looks at the expenses level of a company and how efficient the company is in squeezing out a profit after deducting COGS (at the gross profit level) and expenses. Expenses can be broadly classified into two main categories – selling and marketing expenses, and general and administrative expenses. Let’s further drill down into these two aspects to determine how to arrive at a company’s operating profit.
Selling and marketing expenses consist of the costs of advertising and promotions, direct selling expenses (such as warehousing and logistics costs), as well as listing expenses (for retailers), just to give a few examples. This category would also include the salaries and benefits of the sales and marketing team.
General and administrative expenses would include all other categories of expenses such as depreciation, back-office admin staff salaries, rental of premises, and repairs and maintenance, to name a few.
The operating profit margin can be used to compare firms within the same industry to assess which is generating the higher level of profit per dollar of revenue. For example, two widget manufacturers may have very different operating margin levels depending on their level of expenses, and the company which can minimize its expenses yet generate the same level of sales would be preferred to the company which has a lower level of operating profit margin. The difference in the operating profit margin between two companies from the same industry could boil down to details such as their labour force efficiency, their production floor setup, and other factors – all of which are linked to how well a company organizes its processes and workflow.
As with the gross profit margin, the operating profit margin can also be used to compare the performance of a single company over time. Companies which increase their operating profit margin in a sustainable manner over many years are clearly doing something right by reducing expenses as a proportion of revenue. There are also many cases where economies of scale help to reduce the per unit expense of a company as revenue scales up, as some expenses are fixed and do not increase along with the level of sales.
The next article in this series shall delve into the net profit margin, so stay tuned!
[Editor’s note: The third article in the series discussing the Net Profit Margin has been published. It can be found here.]
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