It all adds up: Understanding your operating margin

 

Businesses, like people, benefit from regular checkups. To make sure that your company is in tip-top, financial health — and to improve your chances of securing investors or lines of credit — you may want to periodically calculate your operating margin.

How? Read on to find out.

 

What is operating margin, and why is it useful?

Operating margin describes the ratio of your operating income to your net sales. It goes by other names, too. It’s sometimes called operating income margin, operating profit margin, return on sales or EBIT (earnings before interest and taxes) margin.

Your operating margin shows your business’s profitability minus production-related expenses, like marketing and administrative tasks. It’s useful because it can help you:

• Determine how much money you’re making per sale: Analyzing your sales data allows you to better understand the profitability of your core business operations.

• Keep track of your money: By monitoring what you’re generating in sales before taxes and expenses (direct and indirect), you’ll be able to see whether you have enough capital for future projects and whether you’re likely to need a cash infusion down the line.

• Benchmark your performance: It’s always a good idea to keep an eye on competitors. If your margin is smaller than theirs, it may be a sign that you could be doing more when it comes to cutting costs or creating cash flow.

Luckily, learning how to calculate your operating margin is straightforward.

 

Calculating operating margin

You can calculate your operating margin by dividing your operating income by your net sales. But don’t pull out your calculator right away. It’s important to note that some income, like investments, should not be included in the figure you use for your operating income. You’ll need to subtract it before making the final calculation.

The formula is Operating margin = Operating income ÷ Net sales, where operating income is the amount of profit from your business’s operations after deducting operating expenses (such as payroll, overhead, the cost of goods sold and depreciation). Net sales are the sum of your business’s gross sales minus your returns, allowances and discounts. 

Operating margin is usually expressed as a percentage.

 

Understanding the limitations

Like any financial metric, operating margin has some limitations. It provides more of a bird’s-eye view of profitability than a detailed analysis of your business’s financial health. In other words, it measures profitability after paying variable costs but before taxes and interest expenses. Earnings before interest, taxes, depreciation and amortization (EBITDA) is another tool for measuring overall profitability.

Also, operating margin doesn’t always offer accurate comparisons across industries and business models. Many analysts use EBITDA for that instead because they can get a fuller picture by taking out the impact of financing, accounting and taxes. Other financial metrics, like profit and loss statements, can also be helpful when it comes to analyzing and creating cash flow. 

 

Operating vs. net profit vs. gross margins

To overcome the limitations of operating margin, you may want to calculate your net profit margin and gross margin as well. Here’s what you need to know:

• Net profit margin: Amount of profit a business makes per dollar of revenue gained. This figure tells you how much net income your business makes from your total sales. Because it focuses on net income, it takes into account all interest and taxes paid.

• Gross profit margin: Net sales minus the cost of goods sold. Gross profit margin explains how much your business retains after incurring the direct costs of doing business. This helps shed light on how efficiently your company is operating.

Many business owners use all three margins to analyze their income activities because each provides a different type of insight. Combined, they show how you are managing both direct and indirect costs, as well as taxes and interest.

 

Putting it all together

Being able to speak to your business’s operating margin and other financial figures can help you demonstrate your business’s financial health to lenders or investors. To learn more about other steps you can take to support your growing business, reach out to a Chase business banker today.