This article explains the fundamentals of operating profit margin and how the value is derived. In addition, operating profit margin is explained as to its proper use with comparing financial performance between two or more entities and why the value has inherent disadvantages. Finally, this article explores some of the more lucrative ways to use this ratio in evaluating a particular investment.
The operating profit margin is one of the 22 different business ratios used when reviewing financial statements of a business. All investors need to remember that it is unwise to evaluate financial performance based on a single ratio as accurate analysis requires using at least a dozen or more ratios.
Operating Profit Margin Fundamentals
The operating profit margin is considered the profit after all operational expenses have been deducted from gross profit. These general administrative expenses include management costs (front and back office), facilities, insurance, office operations, communications, taxes (non-income types of taxes) and licenses. These expenses are also called selling expenses. Here is a simple layout of an income statement for illustration:
Cost of Sales ZZZ,ZZZ
Gross Profit ZZ,ZZZ
– Management $ZZ,ZZZ
– Facilities Z,ZZZ
– Insurance Z,ZZZ
– Office Operations Z,ZZZ
– Communications Z,ZZZ
– Taxes & Licenses Z,ZZZ
Sub-Total Expenses ZZ,ZZZ
Operational Profit ZZ,ZZZ
Costs of Capital:
– Depreciation ZZ,ZZZ
– Amortization Z,ZZZ
– Interest Z,ZZZ
– (Gains)/Losses ZZZ
Sub-Total Costs of Capital ZZ,ZZZ
It is important to understand some critical concepts of operational profit. The operational profit line in the above happens to match the definition of earnings before interest, taxes, depreciation and amortization (EBITDA). Notice how all those line items are deducted from operational profit to derive net profit? EBITDA is a term used mostly with valuation analysis as this indicates the income earned without any capital costs. However, operational profit can include capital costs.
In some industries the cost of capital (long-term debt and equity) is structured. Usually they are the capital-intensive industries such as real estate, manufacturing, transportation and construction. It is possible that operational profit more closely resembles the ‘Profit’ line in the illustration above. If the user restricts the formula to the textbook definition of determining operating profit margin, it can create deceptive results when comparing two dissimilar industries. Worse yet, this problem still exists when comparing two companies within the same industry. One company may include interest while the other excludes the value generating two different results. Compare these two carpet cleaning operations with the same volume of sales.
Carpet Cleaner ‘A’ Carpet Cleaner ‘B’
Sales $1,283,700 $1,283,700
Cost of Sales 605,907 605,907
Gross Profit 677,793 677,793
– Management 193,415 193,415
– Facilities 107,776 107,776
– Insurance 28,491 28,491
– Office Operations 24,405 24,405
– Communications 31,619 31,619
– Taxes & Licenses 49,801 19,111
– Other 7,648 7,648
– Depreciation & Amort. 24,347 -0- .
Operating Profit 210,291 265,328
– Depreciation & Amort. 24,347
– Interest 7,232 7,232
– (Gains)/Losses (740) (740)
Profit Before Taxes 203,799 234,489
– Federal 53,742 53,742
– State -0- 30,690
Net Profit $150,057 $150,057
In the above example, the operating profit amounts are different for both entities, even the profit line is different. The net profit is the same though. However, ‘B’ excludes state income taxes with the taxes and licenses in the expense section whereas ‘A’ follows the Form 1120 tax return guideline of including state income taxes to derive profit before taxes. In addition, ‘A’ follows traditional small business income statement format and deducts depreciation and amortization as a function of expenses. ‘B’ follows the more modern large business format of separating capital expenses (depreciation, amortization, interest and capital gains/ losses) as a separate section. ‘B’s model more closely resembles the earnings before interest, taxes, depreciation and amortization (EBITDA) format to define operating profit. The model used a business greatly affects the margin as a percentage of sales. ‘A’s margin is 16.38% and ‘B’s margin is 20.67%.
The point of the illustration is that operating profit is defined differently within small business. As businesses move toward more volume, their income statements are more in-line with the widely accepted definition of operating profit used by publicly traded companies .
Another important element of the formula is its use as a percentage of sales. Remember it is used as a margin (percentage) of a known, in this case, net sales. Defining sales is critical to evaluating operating profit margin. In publicly traded companies sales is defined as net sales – all sales less discounts, returns and allowances. In small business, a typical revenue section has the following layout:
Gross Sales $Z,ZZZ,ZZZ
Adjusted Sales Z,ZZZ,ZZZ
Returns & Allowances:
Sub-Total Returns & Allowances (ZZ,ZZZ)
Net Sales Z,ZZZ,ZZZ
Other Revenue ZZ,ZZZ
Total Revenue $Z,ZZZ,ZZZ
Take note, net sales is the 100% point as the reference guide for all other values.
All deductions are calculated against net sales NOT gross or adjusted gross sales. This is also true when looking at a franchise income statement. Royalties are generally revenue sharing per the franchise agreement. Therefore, royalties are deducted from adjusted gross sales before calculating franchisee sales and then deducting returns and allowances. The revenue section for a franchisee income statement is much more complicated than the above layout. But the key is that operating profit margin is determined against net sales and not the other revenue section lines.
A third fundamental principle of the operating profit margin is its wide acceptance as the numerator value used with the debt coverage formulas. It is widely believed and accepted that operating profit is used to pay for capital costs (long-term debt and equity costs). This is not 100% correct as taxes do play a role in determining return on equity. However capital costs will include costs of debt service and capital maintenance of fixed assets. Capital maintenance is often characterized with the use of the term ‘Reserves’ or ‘Replacement Reserves’.
No matter which cost the user is trying to relate with operating profit margin, the operating profit margin identifies how frequently it will cover that respective cost. As an example, suppose the operating profit margin is $92,300 and the costs of debt service (principal and interest) over the same period is $31,605. What is the coverage ratio for debt service, i.e. how many times will the operating profit cover debt?
Coverage Ratio = $92,300 = 2.92 Times
Debt Service $31,605
This is an extremely important formula to appreciate as an entrepreneur. Most long-term loans, especially bank loans have coverage clauses in their terms and conditions section of the loan documents. Banks want to know that the business has the ability to service debt as a function of its financial affairs.
The last and most important fundamental, the one every entrepreneur must acknowledge is that the operating profit reflects the businesses’ ability to earn money. All costs after operating profit reflect expenses that are beyond the direct control of the management team. All costs to derive operational profit are costs the business can control or greatly influence. The remaining costs of capital are a direct reflection of the owners and their equity investment. Look at the following costs typically deducted from operational profit to derive net profit. Included is a short analysis as to why the business has no control over the costs.
1) Interest – Debt is often used in lieu of raising equity as it is generally easier to obtain than selling equity positions. Furthermore, the market dictates interest rates.
2) Depreciation – Depreciation is really an industry standard allocation of fixed asset outlays and not a value the management team has control over. Most small business depreciation formulas are tax basis driven and rarely GAAP (Generally Accepted Accounting Principles) or industry established.
3) Taxation – Again, the tax rates are uncontrollable by the business; the government sets these rates.
When the market looks at a businesses’ ability to earn money, they always look at operational profit. The costs after this relate to leverage of capital, fixed assets utility and taxation. These costs have little to do with actual business operations. Even Warren Buffett advocates using the operating profit value in decision-making over net profit .
Now that the reader understands the fundamentals of the operating profit margin, it is time to explain how to use the value in evaluating businesses.
Proper Application of Operating Profit Margin
The operating profit margin is designed to evaluate via comparison either:
A) Two or more businesses in a similar industry with similar characteristics, OR
B) An existing operation’s financial performance over several reporting cycles.
Naturally, the higher the margin the greater the likelihood the business is successful.
100% operating profit margin is impossible unless you are stealing from the customer; even then, there are costs to steal. The reality is that each industry has different reasonable margins. Some companies can start out with lower margins and via economy of scale increase the operating margin. Others may start higher and via economy of scale decrease their operating profit margin. You many think this is fundamental backwards, yet this is still a good business practice because the company is increasing its absolute dollar income which is what business is really all about. Look at this example:
Curt runs a 24 lane bowling alley with a game room on one side of the bowling alley. Every night all 24 lanes are occupied and on weekends there is a line of folks wanting to bowl. Curt’s operating profit margin is currently 23% with an operating profit of $308,000 per year. Curt decides to expand by adding 10 more lanes by moving the game room to an addition constructed by the bar. His lane occupancy rate decreased but more bowlers used the alley. Curt’s operating profit margin dropped to 19% but his actual operating profit is now $426,000 per year. Here is Curt’s comparative results:
24 Lanes 34 Lanes
Sales $1,339,130 $2,242,105
Costs 1,031,130 1,816,105
Operating Profit $308,000 $426,000
Operating Profit Margin 23.00% 19.00%
Which would you rather earn? It is more lucrative to take the $426,000 at a 19% operating profit margin.
Even though the 24 lane model has a higher margin percentage, any good businessman will desire the greater operating income of the 34 lane operation. Operating profit margin as a comparison is only effective if comparing two separate 24 lane bowling alleys. Well educated entrepreneurs do not use this tool to compare dissimilar operations even if the operations are in the same industry.
So far, two distinct rules have been covered when using this business ratio. First, the ratio should be used to compare two or more very similar businesses of the same industry over several consecutive accounting periods. The second rule is that absolute dollar earnings trump percentage comparisons. But even with this, there are inherent disadvantages with using the operating profit margin.
Inherent Disadvantages of The Operating Profit Margin
When a business grows, especially quickly, revenues expand swiftly and often the cost of sales increase at a faster rate. In addition, general expenses expand as a greater percentage of reduced gross profit margin. This means the operating profit margin will decrease. This is exemplified in the Harbor Lanes example above. This lower operating profit margin is misleading especially if interpreted against higher margins in prior years. It is normal to have decreasing operating profit margins in growth industries.
On the other side of this business principle is the tendency for operating profit margins to increase in declining industries. This increasing margin percentage is mostly driven by efficiencies in operations. Growing businesses have a learning curve that costs money driving up expenses. Older operations that are in decline or industries aging out no longer have learning curves. They exercise efficiencies, thus generating an increasing operating profit margin.
Another inherent disadvantage of the operating profit margin is the mistaken belief that this value is also operational cash flow. This belief stems from the fact that operating profit excludes depreciation and amortization. But cash flow is a function of both the income statement and the balance sheet. In addition, cash flow starts at net profit not operating profit.
Even with these inherent disadvantages, operating profit margin does have a useful purpose. It is an ideal ratio to project scale-ability.
Operating Profit Margin Uses and Analysis
So far, this article has identified two uses of the operational profit margin. First it is an ideal comparison ratio between two or more businesses with similar characteristics or secondly, evaluate an existing business over several consecutive financial accounting periods. There are other uses.
A third use of the operating profit margin is its ability to evaluate leverage. To do this, the cost of capital must be known and its impact on sales. As an example, suppose cost of capital is 6% and a $200,000 loan will ramp up sales by $500,000 per year. If operating profit margin is 16.7%, lets find out if leverage is achievable.
First determine the increase in absolute dollars from sales.
Sales Increase $500,000
Operating Profit Margin @ 16.7% = $83,500
Next, calculate costs of the loan.
Loan Value $200,000
Interest @ 6% $12,000
Finally, determine the overall profit improvement in value.
Increase in Operating Profit $83,000
Costs of Loan 12,000
Overall Increase in Profit $71,500
But is this always the case? Often small business entrepreneurs must service this debt by repaying the principal portion. Assume the loan requires $40,000 per year in payback as a function of loan amortization. Now the increase in cash flow is only $31,500.
Can this same loan work at 9% operating profit margin? Let’s find out.
Sales Increase $500,000
Operating Profit Margin @ 9% $45,000
Costs of Loan $52,000 (Interest and Principal)
Net Change in Overall Cash ($7,000) Net cash Flow
The breakeven point is somewhere between 9% and 16.7%. It is actually 10.4%. When looking at this, there is another critical element and that is how long into the future these marginal sales will exist. Often the sales increase is degenerative over time. In year one you may have sales of $500,000 but by year four they may scale back to only $200,000 thus creating issues with debt service. As with most small business decisions, the shorter the time frame out into the future, the more reliable the analysis value(s).
A guiding rule in small business is the higher the operating profit margin the more likely the operation can be scaled higher. Any operating profit margin less than 14% is going to have poor outcomes as to success; sales will have to double or triple in order to reap real benefits.
One last note to the operating profit margin. This ratio is used in evaluating interest coverage and is frequently used with the operating cash ratio (next article in this business ratios series). If you feel uncomfortable with this formula and its uses, please reread this chapter.
Summary – Operating Profit Margin
The operating profit margin is a ratio used in business to compare the controllable profit of two or more entities with similar characteristics in a similar industry. It is defined as the income earned after expenses and before capital costs along with taxes. In small business, it often is inclusive of capital costs and some taxes.
Astute owners use the value to compare the company’s financial performance over successive accounting periods. Use this ratio with at least a dozen others when evaluating stock investments. Never use this ratio in isolation as the decision criterion to buy stock. Act on Knowledge.