- Operating margin is an important financial metric for small businesses to show earnings from the company’s core business operations.
- Business owners can use operating margin to understand operational efficiency.
- A low operating margin can indicate operating costs are too high, while a high operating margin can indicate low financial risk.
High-level metrics can help small business owners determine financial health, identify areas that need attention and determine potential investments. Business owners can use many metrics, such as cash flow, to help understand the financial health and profitability of their business. One of these highly important figures is operating margin.
Understanding what operating margin is and how to calculate operating margin is important to gaining a full picture of your business’s financial health and viability. Ultimately, knowing the ins and outs of operating margin, as well as how operating income, operating expenses and profit margin factor in, can help set you up for future growth and good business decision-making.
What is operating margin?
Operating margin describes the ratio of operating income to net sales for your business. You may also hear operating margin referred to as operating income margin, operating profit margin, return on sales or earnings before interest and tax (EBIT) margin.
Your operating margin compares how much money you make from a dollar’s worth of sales, less the costs of production and raw materials. Put simply, operating margin shows a business’s profitability after production-related expenses. Your operating margin can help you:
- Determine how much money you’re making per sale to better understand the profitability of your core business operations
- Keep track of the money you’re bringing in on sales before taxes and expenses (direct and indirect)
- See if you have the capital needed to invest in future projects or growth
- Identify if you’ll potentially need cash infusion down the line
- Benchmark performance and compare to others in the industry (Are your margins smaller than your competitors? Are there ways to create higher, more-comparable margins?)
Luckily, learning how to calculate your operating margin is fairly simple to do.
How to calculate operating margin
It’s essential for business owners to understand how to calculate operating margins. At the highest level, you can calculate your operating margin by dividing your operating income (which is found on a company’s income statement) by your net sales. Importantly, some income is not included in the figure you use for your operating income (like investments). This income will need to be subtracted from operating income before making the final calculation.
Operating margin formula
The operating margin formula is:
Operating margin = Operating income / Net sales
- Operating income is the amount of profit from your business’s operations, after deducting operating expenses, such as payroll, overhead, cost of goods sold (COGS) and depreciation.
- Net sales are the sum of your business’s gross sales, minus your returns, allowances and discounts.
The ratio is usually calculated as a percentage.
In addition to operating margin, business owners should be aware of other margins that show a business’s financial health.
Limitations of operating margin
Operating margin does have its limitations since it only provides a bird’s eye view of profitability. Even then, it measures profitability after paying variable costs, but before tax and interest expenses. Earnings before interest taxes, depreciation and amortization (EBITDA) is another similar tool for measuring overall profitability but before depreciation and amortization as well.
Also, operating margin doesn’t always offer accurate comparisons across industries and business models. Many analysts will often use EBITDA instead. By taking out the impact of financing, accounting and taxes, they can get a more comparable picture.
Operating vs. net profit vs. gross margins
To solve for limitations of operating margin, other figures can be used to better understand a company’s financial health. Along with operating margins, both net profit margins and gross margins are key figures to be aware of as a business owner. Combined, these three margins will give you a stronger, more complete picture of your financial situation and profitability.
- Net profit margin: The amount of profit a business makes per dollar of revenue gained. This figure tells you how much net income your business makes with your total sales.
- Gross margin: Net sales, minus COGS. Gross profit margin explains how much your business retains after incurring the direct costs of producing the goods you’re selling. This helps shed light on how efficiently a company is producing its product.
These are the three main factors businesses use to analyze their income activities. Together, these figures help paint a holistic picture of business operations relative to the product your company is producing.
How small businesses can use operating margin
Having an accurate, frequently updated picture of your small business’s profitability from core operations is key. It’s not only critical for day-to-day operations and planning long-term investment opportunities but also when looking to involve investors or financial institutions.
Being able to speak to your business’s operating margins and other financial figures can be helpful when seeking lending tools like a small business line of credit. A financial institution will use margin information to understand how you’ll use requested funds as well as to get a general sense of your financial health.
Regularly monitor your operating margin, net profit and gross margin. Also, be sure to keep detailed financial statements and records to get a clear picture of your business’s well-being. The bottom line is that together, these metrics can help you better run your business and shed light on your company’s profitability and financial health for other parties.