In an operating profit margin example, Bill is the founder and CEO of a retail store called Shopco. Shopco recently took a loan. Shopco has experienced a dip in sales, because of the recession, and wants to make sure they can keep net operating profit margin ratio above the limit in their loan agreement. If not, Shopco may have their loan revoked. Shopco decides to prepare for this scenario by looking at their books and finding all relevant numbers. Bill then performs the calculation below.
Shopco was required by the bank to maintain an operating profit margin about 10%. After performing the calculation Bill now knows that his operating profit margin ratio calculation is above this. Bill feels very relieved. He also now has the confidence to survive through his time of difficulty.
The meaning of operating profit margin varies slightly, although the basics stay the same across all industries. This makes it a common and important metric. Operating profit margin ratio analysis measures a company’s operating efficiency and pricing efficiency with its successful cost controlling. The higher the ratio, the better a company is. A higher operating profit margin means that a company has lower fixed cost and a better gross margin or increasing sales faster than costs, which gives management more flexibility in determining prices. It also provides useful information for investors to determine the quality of a company when looking at the trend in operating margin over time and to compare with industry peers.
There are many ways for a company to artificially enhance this ratio by excluding certain expenses or improperly recording inventory. Revenues may also be falsified by recording unshipped products, recording sales into a different period than they actually occurred, or more. Usually, it serves more as a general measurement than a concrete value.
To learn how to price for profit, download our Pricing for Profit Inspection Guide.
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