Interpreting operating profit margins versus net profit margins - Motilal Oswal
Interpreting operating profit margins versus net profit margins - Motilal Oswal

Interpreting operating profit margins versus net profit margins..

An important part of analysis of financial statements is the analysis of ratios. There are various categories of ratio analysis like profitability, leverage, liquidity, solvency and valuations. Within the realm of profitability ratios, there are two ratios that are extremely critical and they are operating profit margins (OPM) and net profit margins (NPM). While operating margins, as the name suggests refers to the profits earned from the core operations of the company, the net profit margins calculate the actual margin earned after considering the effect of interest payments on debt and tax outflows.
In the debate of operating profit margin vs. net profit margin, it is the context that is more important than the content. There are occasions when the OPM is a more useful measure and there are occasions when the NPM is a better and more reliable measure. The key benefits of operating profit margin are that it tells you exactly how profitable the business is in its core operations. When we talk of a steel company, for example, the OPM would just include the profits generated from the steel business. The revenues generated by the steel business and the related costs of the steel business alone will be considered in this case. When non operating costs like interest charges and taxes are also considered, you get the net profit margins. Operating margins also exclude the impact of extraordinary expenses and incomes and as a business assessment it is more reliable.

What do we understand by operating profit margins (OPM)?
The operating profit margin measure the profits generated by the core operations of the business. If we are talking about the steel business then the revenues will consider the income generated by the steel business alone. Incomes like interest on investments will be excluded. When we talk of operating costs we are referring to expenses that are directly attributable to the core steel operations. Thus you will include the cost or raw materials consumed, the fuel used to convert the raw material into steel, the related labour costs, the salaries to manage the administration, depreciation on assets etc. There is a slight nuance here. Why do we consider depreciation as an operating cost when it is not actually incurred? The reason is that depreciation is a non-cash charge and the tax shield on depreciation allows you to reinvest to replenish your core assets. Hence that also becomes a part of your operating expenses. The difference between the operating revenues and the operating costs gives you the operating profits.

The operating margin captures the operating profit as a percentage of the total operating revenues. It not only measures the efficiency of the core operation of steel manufacturing but also captures the financial viability of the core steel business.

Operating Margin = Operating Profits / Operating Revenues

When you evaluate the operating margins it is the trend that is more important than the absolute number of operating profit margins. For example, if the 5 year trend line shows a rising OPM it is a good sign while a dipping OPM trend line clearly shows that the core operations are under pressure. Margins cannot be seen in isolation but have to be compared to industry peers. For example, certain sectors like steel and telecom tend to have lower operating profit margins while sectors like IT, Pharma and FMCG tend to enjoy much higher operating profit margins. Hence OPM comparison across sectors may not be too enlightening. If the OPM is consistently above the sectoral average and is showing a rising trend then it can be interpreted as a good sign.

How to interpret net profit margin (NPM) and what does it indicate?
Net profit margin is the residual profit after meeting other costs like interest and taxes. Operating profits do not consider the leverage aspect but net profit margins consider the impact of leverage and the net impact of taxes too. The table below captures the subtle difference between operating profit and net profit..
 

Income statement of Company Alpha for the financial year ended March 2017   Variables – Company AlphaSub-item calculationsAmount (in INR)Total Revenues 10,00,00,000Cost of Goods Sold 2,00,00,000Gross Profit 8,00,00,000Operating Expenses  Salaries1,00,00,000 Rent1,00,00,000 Utilities50,00,000 Depreciation50,00,000 Total Operating Expenses3,00,00,000    Operating Profit 5,00,00,000   Interest expenses1,00,00,000 Taxes1,00,00,000    Net Profit 3,00,00,000

 
In the above illustration what are the OPM and the NPM?
The OPM will be 50% = 5,00,00,000 / 10,00,00,000
The NPM will be 30% = 3,00,00,000 / 10,00,00,000

The relationship between OPM and NPM
When you analyze companies it is very important to understand the relationship between OPM and NPM. If the NPM is substantially lower than the OPM it means that the leverage of the company is too high and as a result the interest cost is taking away most of the operating profits. This is a hint to the company management to look at its borrowing policy and also at its borrowing costs.

To sum it up, OPM is the key to understand how profitable the core operations of the company are. Is the company doing better than its peers and is the OPM showing a rising trend? If the answer is “Yes” then it is a good sign. Net profit margin is the actual profit that the company earns and that is what the markets will be interested in. The NPM is what stock markets will focus on for valuations because the P/E ratio is calculated based on the net profits. Growth in net profits and rising NPM is considered to be accretive for the valuation of the stock.

Both OPM and NPM have their own role to play in evaluating the health and the attractiveness of the companies. A combination of both gives the best picture!
 

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