Understanding the Operating Margins

Key Takeaways

An essential gauge of a company's profitability is its operating margin, which accounts for variable production expenses like raw materials and labor.

A business needs a healthy operating margin to cover its fixed expenses, such as debt service or taxes.

A company with a high operating margin is likely to be effectively managed and poses fewer risks than one with a lower operating margin.

Investors that conduct a fundamental study of stock also consider other important measures, such as cost of goods sold (COGs), non-cash expenses, and profits before interest, taxes, depreciation, and amortization (EBITDA), in addition to operating margins (EBITDA).

Operating margin is the portion of revenue that a business generates that can be utilized to pay its taxes, stockholders, and loan investors.
It is a crucial metric when determining the value of a stock. With all else being equal, a higher operating margin is preferable.
Investors must understand the company's capacity to produce cash flow from operations in order to appropriately evaluate the majority of stocks. Therefore, it is crucial to comprehend the ideas of operating income and EBITDA.

Fixed and Variable Costs

Depending on the sort of business, there are many different ways to generate revenue. Similarly, operating costs can be classified as either fixed costs or variable costs and come from a range of sources.

Fixed Costs
A fixed expense is one that does not fluctuate much as business activity and revenue do. A prime illustration of this is rent expense. When a business leases or rents property, it typically pays a certain sum every month or every three months. Whether the business is booming or struggling at the time, this sum stays the same.

Variable Costs
A variable cost, on the other hand, fluctuates in line with variations in business activity. The price of purchasing raw materials for a manufacturing operation is one example. When business picks up, manufacturing companies must purchase more raw materials; as a result, the cost of purchasing raw materials rises as revenue does.

When examining operating margins and cash flows, it's frequently crucial to look at a company's operating leverage or the ratio of fixed and variable expenses. When revenue increases, the operating margins of organizations that are fixed-cost intensive have the potential to increase at a higher rate than those that are variable-cost intensive (the reverse is also true).

Cost of Goods Sold (COGS)

The cost (COGS) of goods sold is a unique and significant type of expense. Companies that sell things that they make, add value to or simply distribute use inventory calculations to account for the cost of goods sold. The fundamental COGS formula is:
COGS = BI + P - EI
Where:
BI is beginning inventory
P is inventory purchases for the period
EI is ending inventory

Businesses attempt to calculate the cost of the actual volume of product sold during the time by netting off the beginning and ending inventories.
The primary component of operating income is known as gross profit, which is defined as revenue fewer COGS. Gross profit is the amount of profit made before general overhead costs that cannot be inventoried, such as selling, general, and administrative expenses.
SG&A expenses could cover things like the salary of administrative workers or the price of advertising and promotional materials.
When comparing companies or evaluating the performance of a single company over time, analysts frequently consider gross margin, a percentage that is calculated by dividing gross profit by revenue.

Non-cash expenses

When examining operating statistics, investors should be aware of the distinction between cash expenses and non-cash expenses. An operating expense that does not call for a cash outlay is referred to as a non-cash item on the income statement. Depreciation expense is one instance. General Accepted Accounting Principles (GAAP) state that when a company purchases a long-term asset (such as large machinery), the cost of the item is not expensed in the same way as rent or the cost of raw materials.

Instead, the cost is spread out throughout the equipment's useful life. As a result, even if no additional cash outlay has been made, a small portion of the total cost is allocated to the income statement over a number of years in the form of depreciation expense.

Operational income and operating cash flow are different, and this difference is primarily caused by non-cash expenses. Investors would be good to take into account the percentage of operating income that can be attributed to non-cash costs.

Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)

To measure cash-based operating income, analysts frequently compute profits before interest, taxes, depreciation, and amortization (EBITDA).
EBITDA may be a more accurate way to gauge the amount of operating cash flow that is accessible to investors than operating income because it doesn't include non-cash items. After all, cash, not income, must be used to pay dividends.