The operating profit margin is one type of profitability ratio also known as margin ratio. Operating profit margin indicates the operational efficiency of the company.i.e contributions on company’s profitability.
Calculation of operating profit margin ratio
Operating profit margin ratio = Operating profit/ Net sales x 100
How operating profit is calculated? This profit is calculated by deducting operating costs such as cost of goods sold, administrative costs and selling and distribution cost from the net revenue of the company. We may present operating income in the following manner:
Operating income = Gross Profit – (Operating Expenses + Depreciation & Amortization Expenses)
To calculate operating profit margin following steps to be followed:
- Determine operating income by subtracting its operating expenses (Administrative expenses+Selling & Distribution expenses+Other expenses relating to operations), allocation of depreciation and amortization from company Gross profit.
- Determine the company’s net sales revenue. Net sales revenue is Sales less VAT and discount allowed to the customer.
- Determine operating profit margin ratio by dividing operating profit/net sales.
Example of calculation of Profit Margin ratio
Suppose, this is the Income Statement of ABC Limited Company.
Revenue 72,63,550
Vat & Excise duty (220,150)
Discount Allowed (115,286)
Net Revenue 69,28,114
Cost of Sales (51,75,530)
Gross Profit 17,52,584
Other Operating income 10,18,313
Selling & Distribution Costs (5,75,275)
Administrative costs (3,25,130)
Other Operating expenses (133,120)
Operating Profit /EBIT 17,37,372
Interest Expenses (25,575)
Interest Income 18,258
Profit from investment 13,250
Earning before tax 17,43,305
Income Taxes (33,575)
Net Profit after tax 17,76,880
Using the formula,
Operating Profit Margin Ratio = Operating profit/Net Revenue x 100
Here, Operating Profit = 17,37,372
Net Revenue = 69,28,114
so, Operating profit ratio = 17,37,372/69,28,114 x 100 = 25.08%
Importance of Operating Profit Margin ratio
This ratio is the reliable indicator of a company’s financial health. To judge whether operating profit margin ratio is effective, you have to compare it with other similar companies.
A company which has a high operating profit ratio is better able to pay for their fixed costs and interest on loan, to survive on economical crisis, more competitive than any other company because of their higher profit margin ratio.However, this is a useful indicator of a company’s efficiency.
Limitations of the Ratio
Data provided on financial statement may not accurate, that may provide false operating profit which result might not be reliable or financial statements that were prepared using inconsistent accounting records.
Another limitation is operating margin ratio also does not factor in any qualitative information about a company, nor does it give any indication of the probability of future results.