Which Financial Ratio Is the Best Measure of Operating Efficiency?

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Fundamental analysis is used to determine if a company is a good investment. It uses numbers from a company's income and cash-flow statements as well as its balance sheet to calculate ratios. These ratios are then used to determine a company's worth and its potential for growth. How a company ranks among its peers gives the analyst an indication as to whether it is a good investment.

Profit Margin

Calculating profit margin is a good way to gauge how well a company handles the money it makes. Profit margin is the percentage of each dollar of sales that the company is able to keep. Profit margin is calculated on three different levels, gross profit margin, operating profit margin and net profit margin.

Operating Margin

The financial ratio that is the best measure of a company's operating efficiency is its operating margin. There are certain expenses that are necessary to run a business. These expenses are know as operating expenses. They vary depending on the type of business you are in. Expenses such as raw materials and wages are examples of operating expenses. Operating margin is the percentage of every dollar of sales that a company is left with after operating expenses are deducted.

Calculating Operating Margin

The mathematical formula for calculating profit margin is operating income divided by total revenue equals operating margin. For example, if corporation S has a total revenue of \$78 million and an operating income of \$27 million, you divide \$27 million by \$78 million to get 0.346. Operating margin is usually stated as a percent. If you multiply 0.346 by 100 it equals 34.6 percent. Corporation S has an operating margin of 34.6 percent, which means it is able to keep about 35 cents out of every dollar it earns in revenue after operating expenses have been deducted.

When analyzing profit margin, the higher the number the better. That doesn't mean that a company with a 70 percent profit margin is more efficient than a company with a 40 percent profit margin. Operating margins should always be compared between companies in the same or similar industries. You wouldn't compare the margins of a pizzeria to those of an auto maker. If the margins of one company are much lower than the industry average, it suggests that the company is not being run as efficiently as its peers, which could indicate that money is being wasted.

References

• "Fundamental Analysis For Dummies"; Matt Krantz; 2009
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