Go Premium
What is Profitability?
Profitability is an earned profit after you exclude all operating costs and expenses. In simple words, the profitability ratio helps investors determine if a company makes a decent amount of profit from its business and operations.
Of course, the higher profitability ratio results are always better performance indicators. Still, these ratios need to be compared to results of similar companies, the company’s historical performance, or the industry average.
Types of Profitability Ratios
Several profitability ratios are used in identifying a company’s performance such as gross profit margin (GPM), operating profit margin (OPM), return on sales (ROS), return on assets (ROA), return on equity (ROE), and return on investment (ROI).
This article will explain two fundamental profit metrics: Profit margin (PM) and operating profit margin (OPM).
What Is Profit Margin?
Profit margin is the percentage of sales that the company retains after all expenses have been deducted. The profit margin is calculated by subtracting total expenses from revenue, then dividing by revenue. When comparing similar companies and their profit margins, a higher profit margin can mean the company is good at keeping costs low.
Profit Margin= (Revenue – Costs) / Revenue
If a company’s $100,000 profit reflects a 50% profit margin, we can say that the company is financially healthy. If that $100,000 is a mere 1% over the company’s overall operating expenses, then the company may go into bankruptcy with a slight increase in costs.
Also Read: What Can Islamic Bank Do to Boost Its Profitability?
What Is Operating Profit Margin?
Operating profit margin is a profitability ratio that represents the percentage of profit generated by a company’s operations before taxes and interest charges are deducted. You can calculate the operating profit margin by dividing the operating income by total revenue and making it as a percentage.
Operating Profit Margin= Operating Income/ Total Revenue
Operating income takes into account operating expenses including salary, marketing costs, depreciation, facility costs, transportation costs, and equipment. For this reason, people often call operating profit margin as earnings before interest and tax (EBIT).
Indeed, high operating profit margins mean the company can pay for fixed costs and interest on obligations. Moreover, companies with high operating profits can overcome an economic slowdown easily.
OPM Meaning in Stock Market
In the stock market, OPM is a critical metric used by investors to gauge a company’s profitability from its core business operations. Unlike gross profit margin, OPM accounts for all operating expenses, offering a clearer picture of a company’s ability to generate profit from its primary activities.
OPM Ratio and Percentage
The OPM ratio is essential for comparing companies within the same industry. A higher OPM ratio generally indicates a more efficient and profitable company. The OPM percentage is used to express this ratio, allowing for straightforward comparisons between different companies and industries.
Key Industries with High/Low Operating Profit Margins
Operating profit margins vary significantly depending on the industry and the product or service offered. For example, the technology hardware sector has one of the highest OPMs at around 20%, while the oil and gas industry has one of the lowest at 6.3%. Specialty retailers and software companies also boast high OPMs of around 13-15%.
Meanwhile, sectors like bricks and mortar retail, hospitality, and transportation typically have lower OPMs, ranging from 3-6%. Understanding how different businesses in different industries perform in terms of profitability ratios can help investors and entrepreneurs make informed decisions based on their expectations of growth and risk appetite.
How to Improve Your Business’s Operating Profit Margin?
Improving OPM is critical for businesses that want to remain competitive. To improve operating margin, businesses must consider reducing costs and increasing revenues. Ways to accomplish this include:
- Strengthening the Supply Chain: Optimize supply chain processes to reduce production costs.
- Increasing Sales and Marketing Efforts: Boost revenue through targeted sales and marketing strategies.
- Optimizing Pricing Strategies: Implement dynamic pricing to maximize margins.
- Implementing Automation and Technology: Reduce administrative and staff expenses by automating processes.
- Focusing on Operational Efficiency: Streamline production processes, eliminate duplication of efforts, and reduce waste.
Common Mistakes Affecting OPM
- Poor Cost Management: Failure to control costs can severely impact OPM.
- Rapid Expansion: Expanding too quickly without adequate resources can hurt profitability.
- Over-Investment: Investing heavily without ensuring sustainable growth can reduce margins.
- Cash Flow Issues: Poor cash flow management can negatively impact OPM.
The Role of Operating Profit Margin in Investment Analysis
Investors often use OPM as a crucial tool to evaluate businesses before making investment decisions. Understanding the operating profit margin of companies within an industry can help investors make informed decisions about where to allocate their resources. Specifically, it can help investors assess:
Core Profitability
Core profitability refers to a company’s ability to generate profits from its main business activities, excluding any ancillary income such as investments or one-time sales. This metric is essential because it gives a clear picture of how effectively a company is managing its primary operations. A high level of core profitability indicates strong operational efficiency, cost management, and revenue generation, making the company more attractive to investors. It also highlights the robustness of the business model and the company’s capability to sustain its profitability through its core activities.
Industry Comparison
Industry comparison involves evaluating a company’s performance metrics, such as operating profit margin (OPM), against those of other companies within the same industry. This comparison helps in understanding the company’s relative efficiency and profitability. By analyzing how a company measures up to its peers, stakeholders can gauge its competitive position and identify areas for improvement. This context allows for better strategic planning and informed investment decisions, as it provides insights into the company’s strengths and weaknesses relative to its competitors.
Cost Control
Effective cost control is crucial for maintaining and improving profitability. It involves managing and reducing unnecessary expenses while ensuring that quality and performance are not compromised. This can be achieved through various strategies such as optimizing supply chain processes, implementing cost-saving technologies, and streamlining operations. Good cost control measures help in enhancing operating profit margins by ensuring that resources are used efficiently and waste is minimized, thus directly contributing to a company’s financial health.
Sustainability
Sustainability refers to a company’s ability to maintain its operations and profitability over the long term while minimizing negative impacts on the environment and society. It encompasses financial health, environmental and social governance (ESG) practices, and strategic planning. Sustainable companies often have strong balance sheets, are resilient in the face of economic downturns, and engage in practices that promote long-term growth and stakeholder value. By focusing on sustainability, companies can build a solid foundation for enduring success and contribute positively to the broader community.
The Impact of Economic Conditions on Operating Profit Margin
The operating profit margin can be significantly impacted by economic conditions. Economic downturns can cause temporary or permanent changes to a business’s revenue and expenses. In such instances, OPM will provide an indication of the business’s ability to ride out difficult times.
Additionally, the competitiveness and composition of the market may change, causing a shift in competitor behavior and increasing the potential for cost increases. In this case, OPM can aid businesses in adapting to the new reality of market conditions and taking measures to remain profitable.
Analyzing Competitors’ Operating Profit Margins for Comparative Evaluation
By analyzing competitors’ operating profit margins, businesses can gauge how they measure up in the wider industry and understand how to better position themselves. This analysis is critical to see how peers are responding to changes and developing effective ways to match or exceed peers’ performance.
The data can then be used to identify gaps in cost management practices, pricing strategies, and the overall business approach while adopting tactics that allow companies to be more competitive and potentially gain market share.
Using Operating Profit Margin to Forecast Future Performance
By analyzing changes in OPM, businesses can forecast future performance. For example, operating profit margins declining over an extended period could signal a business experiencing difficulty. In contrast, an improving OPM may serve as a sign that the company is becoming more efficient, and earnings are set to rise. Knowing this information can help businesses set realistic and achievable goals, designed to address challenges as they arise, and capitalize on opportunities to drive growth.
Case Studies: Successful Companies with High Operating Profit Margins
Several companies have successfully implemented measures to achieve high OPMs. Some notable examples include:
- Apple Inc.: At 24%, the company’s success is attributed to a well-structured supply chain, an excellent brand reputation, and consistent innovation.
- Amazon.com Inc.: At 5.5%, it has achieved its success by securing a considerable market share, keeping overheads low, and increasing revenue by capturing market share.
- Alphabet Inc.: At 22.2%, Alphabet (Google) is renowned for its comprehensive online search engine platform and diversified revenue streams.
Implications of Low or Negative Operating Profit Margins
Low or negative OPMs can indicate a business is in trouble. It could mean the expenses are higher than revenue or the company is operating in a highly competitive market with low-profit margins. It is essential for businesses with low/negative OPMs to take swift action to address the root cause of the issue, such as improving cost management, optimizing pricing strategies, or boosting operational efficiency.
You May Also Want to Learn About: Debunking the 5 Biggest Myths of Stock Market
FAQs about Operating Profit Margin (OPM)
- What does a high operating profit margin indicate? A high OPM indicates that a company is efficient at managing its operating expenses and is generally more profitable. It suggests the company can withstand economic downturns better and has robust financial health.
- How is operating profit margin different from net profit margin? OPM focuses on profit generated from core operations before taxes and interest, while net profit margin considers all expenses, including taxes and interest, giving a comprehensive view of overall profitability.
- Why is OPM important for investors? Investors use OPM to evaluate a company’s operational efficiency and compare it with industry peers. It helps in assessing whether the company is managing its resources well and is a good investment option.
- What are typical OPM values for different industries? OPM values can vary widely across industries. For example, technology companies often have OPMs around 20%, while industries like oil and gas may have OPMs as low as 6%. It’s crucial to compare OPM values within the same industry for an accurate assessment.
Access stock’s Shariah compliance status, detailed reports, super investor portfolios, and more with the Musaffa App. Unlock
smart Halal investing and gain insights with our stock forecasts and purification calculator.