Operating margin ratio

The operating margin ratio shows the proportion of operating income to the net sales of a business. The calculation is:

Operating income / Net sales = Operating margin ratio

For example, a business generates $120,000 of operating income on $1,000,000 of net sales. It has generated an operating margin of 12%. This is one of the most important income statement ratios, since it reveals the profitability of the core operations of a business, excluding any impact of its financial structure. A high operating margin ratio is needed by a business that is highly leveraged, since it must spend more money on interest expense than a firm that is funded with a lesser amount of debt.

The operating margin ratio is commonly used when comparing the profitability of different firms within the same industry, since they should all have roughly the same cost structures. Those firms with better cost controls and higher-margin products will score better in this comparison.

The operating margin tends to decline as a business increases in size, for two reasons. First, it tends to expand into business lines that are less profitable as it pursues increased sales. And second, organizations tend to increase in complexity as they grow, which results in more corporate and administrative overhead expenses.

Related Courses

Business Ratios Guidebook 
The Interpretation of Financial Statements