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Operating margin measures operating income against revenue
What Is Operating Margin?
Operating margin is a profitability ratio that measures operating income relative to revenue. It’s a type of profit margin used to evaluate the performance of executive management on their effectiveness in generating revenue and maintaining profitability. Operating margin also is referred to as operating income margin, EBIT margin, and return on sales.
Operating income is a major component of operating margin and is found as a line item in the income statement of a company’s regular quarterly and annual filings with the Securities and Exchange Commission. Operating income is listed below operating expenses but above income expenses and tax payments.
Operating income is often used interchangeably with the acronym EBIT, which stands for earnings before interest and tax, and that is the reason EBIT margin is often referred to as operating margin. While operating income is calculated on a top-down basis from revenue, EBIT is calculated by working upward from net income, referred to as the bottom line. Interest expenses and tax provisions subtracted from net income become the EBIT figure. Either method of calculation delivers the operating income figure that is divided by revenue to bring in the operating margin. The difference between the two is the approach on profit: Operating income focuses on subtracting operating expenses and cost of goods sold from revenue, while EBIT focuses on profit before interest costs and tax payments are deducted.
How to Calculate Operating Margin
Operating margin is the quotient of operating income divided by revenue.
Operating Margin = Operating Income / Revenue
Below is an example of Home Depot’s net income from 2018 to 2020. The data show that the retailer’s operating margin held steady from 2018 to 2019 as costs were kept in check relative to the increase in revenue, but slipped between 2019 and 2020 because the rate of change in selling, general and administrative expenses was higher than that for net sales and cost of sales.
How Is Operating Margin Used?
Operating margin can be used to highlight executive management’s efficiency in handling profitability. A breakdown in operating expenses would show specific areas that could indicate specific areas for improvement. For example, a pick-up in selling, general and administrative expenses in one quarter could lead executive management to evaluate what factors led to the increase and find ways to keep costs under control in subsequent quarters.
In general, a higher ratio from the latest period over the previous period would suggest that the company is managing its costs or boosting revenue. A lower ratio would indicate that profitability is slipping and might require some adjustment by executive management.
What Are the Limitations of Operating Margin?
Operating margin deducts expenses tied to sales and the company’s normal business activities. The ratio excludes interest expenses and tax payments, both of which can have a significant impact on profitability, especially if a company has more debt than equity and is in a high corporate tax rate bracket.
Frequently Asked Questions (FAQ)
The following are answers to some of the most common questions investors ask about operating margin.
What Is a Good Operating Margin?
A 2015 report put the average operating margin for companies with market capitalization exceeding $1 billion at 13 to 14 percent. Having a margin at or above average would be considered good.
Can Operating Margin Be Negative?
Operating margin can be negative if operating income is negative. If that’s the case, it would indicate cost of sales and/or operating expenses exceeding revenue.
Is Operating Margin the Same as Return on Sales?
Return on sales uses the same method of calculation as EBIT, and that is also divided by revenue.
