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Determine how stable or profitable an organization is
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A company’s operating margin is one of the most important figures you can use to assess a company’s health, profitability, and efficiency. To put it simply, a firm’s operating margin is how much profit is left over after paying for the costs of production. However, this isn’t a standard line item in accounting—so you often won’t find it in a company’s books or 10K—which means you’ll need to calculate the margin yourself. In this article, we’ll show you how to do it. Then, we’ll explain why this number is so key if you’re a business owner or investor.
Things You Should Know
- The formula for operating margin is: Net sales – (cost of goods sold + SG&A) / Net sales x 100% = Operating profit margin.
- Operating margin, also known as operating profit margin or return on sales, represent how much money a company earns at the end of the day.
- Investors and business owners use operating margin to assess how efficient and profitable a company is.
Steps
Section 2 of 7:
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Start by adding your sale, general, and administrative expenses. A company’s sales expenses include things like the costs of marketing, distribution, logistics, and insurance. General expenses are the rent for the company building, utilities, computer equipment etc. Administrative expenses include benefits, salaries, and wages. Multiply these together to get the SG&A in the formula.
- Let’s say a company spends $50,000 on sales expenses, $12,000 on general expenses, and $120,000 on administrative expenses. This comes out to a total SG&A of $182,000 .
- Remember, your general expenses are only for the most recent quarter (or year depending on how far back you’re looking). The computer you bought this month is an expense. A computer from last year is an asset.
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Add the SG&A to your cost of goods sold. The cost of goods sold includes all of the costs and expenses that pertain to your production of goods—what most people call “overhead.” If you sell stuffed animals, for example, this might include the cost of yarn, stuffing, needles, and stitches. If you sell a home cleaning service, the cost of goods sold might include cleaning supplies, marketing, and phone bills.
- You might ask yourself, “Wait, you just said marketing is a sales expense?” Some income statement line items are flexible depending on where you put them. So long as you don’t “double dip” by including something twice, you’re good. [2] X Research source
- For our example, let’s say a company has a cost of goods sold totaling $20,000 . We add this to our SG&A to get a total of $202,000 .
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Subtract that number from your net sales. The net sales , also known as the total revenue , is all of the money that comes into the business as a consequence of your work with clients (minus things like returns, discounts, etc.). Subtract the cost of goods and SG&A from your net sales.
- If you have a positive number, the company is said to be “negative revenue” or “pre-revenue.” This means they’re operating at a loss.
- For our example, let’s say the company’s net sales come out to $280,000 . $280,000 – $202,000 leaves the company with $78,000 .
- This $78,000 can also be called the company’s EBIT . This stands for earnings before income and taxes .
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Divide that number by your net sales. Take the same net sales you just used to calculate the top line item of the main equation. This gives you the operating income as a fractional number.
- In our example, we’ve got a top line item of $78,000 . We divide this by the company’s net sales, which we’ve established are $280,000 . This gives us a fractional operating income of 0.2785 .
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Multiply the final number by 100 to get your operating profit margin. This simply turns the number into a percentage . Traditionally, you drop everything after the whole number and you round up or down depending on whatever is closer.
- Note, if you’re keeping books , you must include a footnote or explanation that you’re rounding up or down.
- So, take 0.2785 and multiply it by 100 to get a final operating margin of 28% .
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Tips
- The other two multiples (or ratios) that matter a lot to investors are the asset to debt ratio and the P/E ratio. Together with the operating margin, these three figures tell you a lot about a potential investment!Thanks
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References
- ↑ https://www.sec.gov/oiea/reports-and-publications/investor-publications/beginners-guide-financial-statements
- ↑ https://www.pwc.com/gx/en/ifrs-reporting/pdf/europesurveynongaapmeasures.pdf
- ↑ https://www.sec.gov/oiea/reports-and-publications/investor-publications/beginners-guide-financial-statements
- ↑ https://www.fool.com/investing/how-to-invest/stocks/operating-margin/
- ↑ https://www.fool.com/investing/how-to-invest/stocks/operating-margin/
- ↑ https://corporatefinanceinstitute.com/resources/accounting/burn-rate/
- ↑ https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins/how-read
- ↑ https://www.marketplace.org/2022/05/13/how-do-grocery-stores-make-money-when-their-profit-margins-are-so-low/
- ↑ https://www.businessnewsdaily.com/11096-determining-profit-margins.html
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