Operating Performance Measurement
Operating income can be used to measure the overall health of a company’s core operations. Profits are one of the most important numbers to review when considering an ownership stake in the company by purchasing common stock or lending your money to the company through an investment in its corporate bonds.
Unless the company has a lot of assets that can be sold, any money it pays out to shareholders as dividends must be generated from the sale of a product or service. If the company is experiencing a decline in operating income, it has less money for the owners, expansion, reducing debt, or anything else management hopes to achieve.
Lenders and shareholders often closely monitor operating profits. This can pose certain challenges, as corporate operating income can swing significantly with economic conditions.
These types of companies are known as cyclical companies. They consist of companies such as steel mills, aluminum manufacturers, automobile manufacturers, heavy equipment manufacturers, hotels, resorts, home builders, and many luxury goods manufacturers, such as high-end jewelry companies.
These companies may still generate a good amount of money, but they will not have a smooth upward trend in operating income because businesses are likely to contract during recessions and depressions.
Note: When evaluating the value of cyclical companies, one year of operating profit in isolation will not tell you what you need to know, so work with at least two or three years of historical data before drawing your conclusions.
Operating Income
Gross profit is produced by subtracting the cost of goods from the company’s total revenues. Below gross profit on the income statement, you will find the company’s operational expenses. These expenses include wages and sales expenses, marketing costs, and various office expenses such as utilities and office supplies.
Use the following formula to calculate operating income using inputs from the income statement:
Gross profit – Operating expenses = Operating income
Calculating Operating Margin
To calculate the operating margin, divide the resulting operating income from above by total revenues.
Operating income / Sales = Operating margin
Whether the percentage qualifies as a good operating margin depends on the industry. However, you can get a benchmark by comparing the operating profit margin of the company with the S&P 500 index. If the target company’s operating profit margin exceeds the S&P 500 return, you may have found a company that outperforms the market.
Interpreting Results
Companies review the operating profit margin, or operating margin, as a measure of management efficiency. Calculating the profit margin produces a result that helps compare the financial performance quality of the company with its competitors.
A company that achieves a higher operating profit margin than others in its industry generally has better performance, as long as the gains did not come from taking on large amounts of debt or through speculative risks with shareholder funds.
The most common reason for companies to achieve high operating profit margins compared to their competitors is due to a low-cost operating model. This is when a company finds a way to deliver goods or services to customers at much lower prices than the competition while still making a profit.
A classic example is Walmart, which can offer everything from toothpaste to socks in its stores at much lower prices than the competition due to the efficiency of its warehouse distribution system.
Source: https://www.thebalancemoney.com/operating-income-and-operating-profit-margin-357587
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