An important part of the 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, refer 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.

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What do we understand by operating profit margins (OPM)?

The operating profit margin measures the profits generated by the core operations of the business. When discussing the steel business, the revenues refer to the income generated solely by the steel business. 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 of 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 operating revenues and operating costs yields the operating profit.

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 Alpha Sub-item calculations Amount (in INR)Total Revenues 10,00,00,000Cost of Goods Sold 2,00,00,000Gross Profit 8,00,00,000Operating Expenses Salaries 1,00,00,000 Rent 1,00,00,000 Utilities 50,00,000 Depreciation 50,00,000 Total Operating Expenses 3,00,00,000 Operating Profit 5,00,00,000   Interest expenses 1,00,00,000 Taxes 1,00,00,000 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 understanding 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 attractiveness of the companies. A combination of both gives the best picture!

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