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The importance of operating margins for a company

What do we understand by operating margins and why is it so important from an analytical perspective. Operating profits are the profits generated by the core business. For example, if the company in question is in the business of making steel, then the core profits generated from steel manufacture will be referred to as operating profits. An aspect of operating profits is that it does not consider the impact of debt, so interest will be a post operating profit appropriation. But why is operating profit so important? Firstly, let us understand the concept of operating profit for a company..

Understanding the crux of operating profits..
While operating profit is more of an analytical usage, the real accounting usage is EBIT (Earnings before Interest and Tax). Please note that operating profits are calculated after considering the impact of depreciation. One can argue that depreciation is not an actual expense but just a provision. But then, what is this depreciation provision for? The reason is that when you debit depreciation you get a tax shield to the extent of 30% of the depreciation amount. This tax shield will be used to replenish your productive manufacturing assets over a period of time. From that perspective, depreciation too is an operating expense. Now let us look at the accounting explanation of Operating Profits..

ParticularsFiscal year 2018-19ParticularsFiscal year 2019-20Sales RevenuesRs.1,50,00,000Sales RevenuesRs.2,10,00,000Cost of Goods SoldRs.80,00,000Cost of Goods SoldRs.1,12,00,000Gross ProfitRs.70,00,000Gross ProfitRs.98,00,000Admin ExpensesRs.20,00,000Admin ExpensesRs.20,00,000DepreciationRs.15,00,000DepreciationRs.15,00,000Operating ProfitRs.35,00,000Operating ProfitRs.63,00,000

Now let us break up the operating profit performance of the Company X for 2 years. There is something interesting to note here. In the fiscal year 2018-19 the company was operating at below its capacity. Therefore, in the next year it is able to grow its sales revenues by 40% without adding on to its fixed costs (which we will come back to later). Note that when the revenues are up by 40%, the gross profit is also up by 40%. But since this growth is coming from better capacity utilization, the fixed costs in terms of administrative expenses and depreciation is the same. As a result, in spite of the revenues growing by just 40%, the operating profits are growing by 80% on a YOY basis. That is because the benefits of better and fuller absorption of fixed costs are being reflected in the second year. That is why operating profits are important as they show how efficiently the company is able to absorb its fixed costs through fuller utilization of its available productive capacity.

Now, let us turn to operating margins..
Operating profit margin (OPM) is nothing but relationship between the operating profits and the sales revenues of the company. What is the OPM in the above case?
OPM for FY 2018-19 = 35,00,000 / 1,50,00,000 = 23.33%
OPM for FY 2018-19 = 63,00,000 / 2,10,00,000 = 30.00%

In the above instance we can see that not only has the operating profit grown by 80% when the sales have grown by 40% but even the operating profit margins have improved from 23.33% to 30.00%. Of course, if the company is already operating at close to full capacity then the scope for further improvement in OPM is limited unless the company s able to improve its price realizations substantially or reduce its costs substantially. We shall evaluate this point in greater detail in the subsequent paragraph.

The importance of OPM for company analytics..
Why is OPM or Operating Profit Margin such an important metrics for analyzing a company? The importance of OPM stems from the following factors..

Operating profit margin is a good indicator of how profitable the core business of the company is. For an analyst, a company is truly valuable when it is able to generate value from its core operations and not from any financing activity or financial engineering.

OPMs are indicative of how efficiently the company is being operated. For example, a sound company is one that is growing its operating profits at a rate that is better than its revenue growth. This kind of growth advantage must be maintained consistently quarter after quarter.

The sustainable operating profit of the company over a period of time is a good indicator of how much debt the company will be able to take on its books. Most companies face financial stress when the operating profits are insufficient to cover their cover costs. This problem can be resolved if the sustainable operating profit is used as a guide for adding debt to the balance sheet.

Finally, analysis of operating profit helps you give a good idea of what is driving the growth in operating profits and whether it is sustainable. Operating profits are either driven by pricing power in sales or by better cost management as many Indian companies enjoyed when crude oil prices were falling. Once you identify the precise factor driving OPM, you can take a call on its sustainability.

OPM or operating profit margin forms one of the cornerstones of evaluating the health, profitability and efficiency of a company. Rising OPM is good but sustainable OPM is still better!

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