As a small business owner, you may generally know that you’re making a profit in your business, but are you really on top of your income and expenses? Do you have insight into how financially stable your business is? Do you know your operating margin?
Understanding it can help you determine how to increase profitability and stability by lower operating expenses.
What is Operating Margin?
Operating margin (also referred to as Earning Before Interest and Taxes) shows you how much profit you are making after paying operating expenses like cost of goods sold and wages. Your margin is calculated before paying tax or interest.
Your operating margin can be an indicator of how well your company is being run, and many investors and lenders will ask to see it if you are seeking financing or funding.
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 Income ÷ Total Revenue = Operating Margin
If you have assets that depreciate or amortize, you might 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’ll dive further into how to use these gross margin ratios to determine net income and total revenue in the next section.
How to Calculate Operating Profit Margin
Here’s a little help with that accounting calculation to determine your operating margin.
First, Calculate Your Cost of Goods Sold
Your cost of goods sold (COGS) refers to all the fixed costs, as well as administrative costs, that go into the products you sell, whether you buy them already made or manufacture them yourself.
Let’s say you sell water bottles. The costs involved per bottle include:
- Materials – $3
- Labor – $2
- Overhead costs – $1
- Shipping – $2
So your cost of goods sold per bottle would be $8.
Now Calculate Your Selling, General, and Administrative (SG&A) Costs
We’ve covered what’s involved in creating a water bottle, but we haven’t calculated other operating costs that aren’t specifically tied to a product. These include costs like commercial real estate, utilities, marketing, and office equipment.
If you use accounting software, the SG&A will be a line item on your income statement, so you may not need to bother calculating it manually.
Don’t Overlook Other Administrative Expenses and Fixed Costs
There may be other costs you haven’t yet included that will be important to factor in when calculating your operating margin, such as research and development costs or fixed assets that undergo depreciation and amortization for tax purposes.
Once you have calculated your COGS, SG&A, and any other operating expenses, subtract these numbers from your total revenue to get your operating income. Then plus those two numbers into the formula above to get your operating margin.
Let’s say your total revenue is $1 million and your operating income $250,000. We plug these numbers into our operating margin formula:
250,000 ÷ 1,000,000 = .25
You get .25. If you want to make that a percentage, multiply it by 100 to get a 25% operating income ratio.
Why Operating Margin Matters for Small Businesses
So why does this margin matter? It can give you a good indicator of your company’s profitability, which gives a sense of how stable your business is, and how able it might be to weather tough economic times.
If you’re applying for a small business loan or seeking investors, your operating margin, as well as other profitability ratios, can tell lenders and investors how risky your business might be to invest in. Simply looking at net sales, financial statements, and revenues may not tell the full story, but operating margin paints a more accurate picture of the business’s health, past, present, and future.
If you’ve had a great year, investors may want to know if that’s an anomaly or likely to continue into the future. Looking at past operating cash flow and profit margins can help them understand whether this boost in sales might last.
A good operating margin is a high one. The higher your income divided by revenues, the more likely you will be able to pay back financing and interest, which is, of course, a concern to investors and lenders. And if you have a high net profit, you can likely afford to compete with others in your space by dropping your prices to squeeze 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 profit margin
- 20%: high operating margin
How to Use Operating Profit Margin
Just like you keep tabs on accounting documents like your income statement or balance sheet, it’s a good idea to keep an eye on your net profit, cash flow, and operating profit margin.
Whether your accounting software determines it for you or you use an operating margin calculator or just the formula above, update this number at least annually to better understand the health of your business.
Then if you plan to seek funding from investors or a loan, be prepared to show this number if asked for it.
Limitations of Using the Operating Profit Margin Ratio
While in a bubble, your operating profit margin ratio is useful for providing insight into your business’s financial health only.
But often, lenders and investors use it to compare your business to others in your industry. It’s sometimes challenging to compare Gala apples to Pink Lady apples, so to speak. Even if you’re of a similar size to other businesses you’re being compared against, how you calculate taxes, amortization, interest, and depreciation may skew those numbers.
If you feel like your profit margin ratio doesn’t accurately reflect the health of your business, offer to provide other financial documents, like your income statement, data on sales, or cash flow statement to show the bigger picture.
Nav’s Final Word: Operating Profit Margin
Even if you’re not an accountant—especially if you’re not one—understanding profitability metrics like your operating margin and free cash flow can help you better predict and plan for growth of sales in the future.
Spend time with this number and look for ways to improve it so that you are more appealing to investors and lenders. Also, don’t underestimate the impact that your personal and business credit scores may have on your ability to secure financing. Keep an eye on your business credit report to ensure that your financial transactions are reported accurately, and take advantage of getting access to your free business credit scores on Nav.
This article was originally written on August 13, 2020.