Operating margin: what is operating margin, why is it important for businesses
As a small business owner, you may generally know that you are making a profit in your business, but are you really on top of your income and expenses? Do you have any idea of the financial stability of your business? Do you know your operating margin?
Understanding this can help you determine how to increase profitability and stability while reducing operating expenses.
What is the operating margin?
Operating margin (also called Earnings before interest and taxes) shows you the profit you make after paying operating expenses such as cost of goods sold and wages. Your margin is calculated before paying taxes or interest.
Your operating margin can be an indicator of how well your business is running, and many investors and lenders will ask to see it if you are looking for financing or financing.
Operating margin formula
If you don’t have accounting software that will formulate your operating margin ratio, you can easily calculate it yourself with this formula:
Operating result ÷ Total turnover = Operating margin
If you have assets that are depreciating or amortizing, you can use this formula instead:
Gross income – (OE + DA) = EBIT
You subtract your operating expenses (OE) combined with your depreciation and amortization (DA) from gross income to get your EBIT (Earning Before Interest and Taxes). We will discuss in more detail how to use these gross margin ratios to determine net profit and total revenue in the next section.
How to calculate operating profit margin
Here is a little help with this accounting calculation to determine your operating margin.
First, calculate the cost of goods sold
Your cost of goods sold (COGS) means all fixed costs, as well as administrative costs, that go into the products you sell, whether you buy them already manufactured or manufacture them yourself.
Let’s say you sell bottled water. The costs involved per bottle include:
- Materials – $ 3
- Labor – $ 2
- Overhead – $ 1
- Shipping – $ 2
So the cost of goods sold per bottle would be $ 8.
Now calculate your selling, general and administrative (SG&A) costs
We’ve covered what it takes to create a water bottle, but we haven’t calculated any other operating costs that aren’t specifically related to a product. These include costs such as commercial real estate, utilities, marketing, and office equipment.
If you are using accounting software, the SG&A will appear on a line in your income statement, so you may not have to worry about calculating it manually.
Don’t neglect other administrative expenses and fixed costs
There may be other costs that you have not yet included and that will be important to take into account when calculating your operating margin, such as research and development costs or fixed assets that experience a loss. depreciation and amortization for tax purposes.
Once you have calculated your COGS, SG&A, and all other operating expenses, subtract those numbers from your total income to get your operating income. Then add these two numbers into the above formula to get your operating margin.
Let’s say your total income is $ 1 million and your operating income is $ 250,000. We incorporate these figures into our operating margin formula:
250,000 1,000,000 = 0.25
You get 0.25. If you want to make it a percentage, multiply it by 100 to get an operating profit ratio of 25%.
Why operating margin matters to small businesses
So why is this margin important? This can give you a good indicator of how profitable your business is, giving you a sense of how stable your business is and how well it can weather tough economic times.
If you are applying for a small business loan or looking for investors, your operating margin, along with other profitability ratios, can tell lenders and investors how risky your business can be to invest. Just looking at the net sales, financials and revenue may not tell the whole story, but the operating margin paints a more accurate picture of the health, past, present and future of the business. ‘business.
If you’ve had a great year, investors might want to know if this is an anomaly or if it is likely to continue into the future. Examining past operating cash flow and profit margins can help them understand whether this increase in sales could last.
A good operating margin is a good margin. The more your income divided by the income, the more you will be able to repay the financing and the interest, which is, of course, a concern for investors and lenders. And if you have a high net profit, you can probably afford to compete with others in your space by lowering your prices to crowd out the competition.
What is a good operating profit margin?
While the answer to this question may depend on your industry and what phase your business is in, when looking at your accounting financial statements, use these numbers as a rule of thumb.
- 5%: low operating margin
- 10%: average operating margin
- 20%: high operating margin
How to use the operating profit margin
Just as you keep an eye on accounting documents such as your income statement or balance sheet, it makes sense to keep an eye on your bottom line, cash flow, and operating profit margin.
Whether your accounting software determines this for you or you use an operating margin calculator or just the formula above, update this number at least once a year to better understand the health of your business.
Then, if you plan to seek financing from investors or a loan, be prepared to include this number if asked.
Limitations of Using the Operating Profit Margin Ratio
While you are in a bubble, your operating profit margin ratio is useful for providing insight into the financial health of your business only.
But often lenders and investors use it to compare your business to others in your industry. Sometimes it’s hard to compare Gala apples to Pink Lady apples, so to speak. Even if you are of a similar size to other companies you are compared with, the way you calculate taxes, depreciation, interest, and depreciation can skew these numbers.
If you think your profit margin isn’t accurately reflecting the health of your business, offer to provide other financial documents, like your income statement, sales data, or a cash flow statement to show a view. overall.
Nav’s final word: operating profit margin
Even if you are not an accountant—mostly If you’re not, understanding profitability metrics like your operating margin and free cash flow can help you better forecast and plan for future sales growth.
Spend time with this number and look for ways to improve it to be more attractive to investors and lenders. Plus, don’t underestimate the impact your personal and work credit scores can have on your ability to get financing. Keep an eye on your commercial credit report to ensure that your financial transactions are reported accurately and to take advantage of access to your free business credit scores on Nav.
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