Many investors never really look at company financials. By neglecting that aspect of their financial education, they miss out on some of the most useful information that financial data can provide. In particular, measures like margins can tell you how efficient a company is in converting the sales it generates into profits for shareholders. One type of margin known as operating margin focuses on an intermediate step in the financial statement, and it's something that you can use to focus on the core elements of a business to see how profitable it is.
What operating margin is
The definition of operating margin is simple. To calculate it, take the company's operating income and divide it by its total revenue. The resulting percentage is the operating margin.
However, that definition doesn't really tell you why operating margins are interesting. To understand that, it's helpful to look at what goes into getting you from total revenue to operating income.
What you take out of total revenue to calculate operating income
Total revenue includes every penny that the company receives from selling a product. It doesn't include any of the costs involved in generating business activity. Operating income includes some but not all of those costs.
The first thing that the income statement does is calculate gross profit. That's done by taking out the direct cost of the goods or services that the company sells. For instance, if a company sells lemonade, then the costs of lemons, water, and sugar all go into the cost of goods sold.
After that, you also have to account for ancillary costs of doing business. All companies have general overhead expenses, also referred to as selling, general, and administrative expenses. Items like obtaining space for corporate offices, utilities, and paying for professionals to put together information to comply with regulatory requirements are all examples of what can come under general overhead.
Companies also typically spend money on research and development. That expense gets taken out of revenue. Finally, if a company has fixed assets that must be amortized or depreciated, the appropriate allowances come out at this point. Subtract all those items, and you have operating income, from which you can determine operating margin.
What operating margin doesn't tell you
Even though operating margin is helpful, it doesn't include every expense a company bears. Interest income and expenses aren't included in operating income, and items of income or loss from foreign exchange impacts also get taken out further down on the income statement. One-time restructuring, impairment, and other charges are also typically missing from operating income, as are income tax expenses.
Still, operating margins are useful for two purposes. Comparing operating margins for the same company from two different time periods will give you a sense of any progress or erosion in improving profitability. Comparing operating margins across companies in the same industry can be helpful in figuring out which company takes better advantage of opportunities.
Operating margins are a simple concept, but they carry a lot of information. By inviting you into a deeper look at the income statement, operating margins serve a valuable purpose that all investors should realize.
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