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The operating margin is the ratio of a company's operating income to its total sales. This effectively shows how much of each dollar the company takes in sales that it keeps as profit. Comparing the ratio over time or between companies can show the fundamental performance of a company's business operations.
The operating income used to calculate the operating margin is simply the difference between operating revenues and operating expenses. In effect, it is the profit or loss from a company's trading. The figures don't include non-trading expenses, such as interest on loans or tax payments.
Operating income is known in the United Kingdom as operating profit. The term is also often used interchangeably with EBIT, or earnings before interest. Strictly speaking, there is a slight difference between operating income and EBIT: the latter will also take account of non-operating income. This is income from sources other than the company's trading, such as interest on loans it has made to other companies, or dividends and interest on investments.
The main advantage of using the ratio is that it is simple to calculate and gives a clear snapshot of how well a company's trading is going. For example, a company with an operating margin of 20% will make a 20 cent pre-tax profit on every dollar (USD) it takes in revenue. This also makes comparisons between various companies simpler.
A company with a high operating margin is not necessarily in great financial shape, as it may have heavy debt obligations. Similarly, a company with a low operating margin may be in good shape if it is debt-free or trades in a region with low taxes. In both cases, the ratio is simply a useful way to see how the company's trading activity is likely to affect its underlying financial strength over time. It also gives some insight into a company's susceptibility to risk: a company with a low operating margin may be in trouble if demand for its products drops or production costs rise unexpectedly.
There are some figures that may be left out of operating margin calculations, even though they are technically part of operating profits. One example is payments made in court cases. Although these can be significant parts of cash flow, they are discounted from the operating margin as they aren't a fair representation of the ongoing costs and revenues of the core business.