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Determine operating efficiency

As the name suggests, operating efficiency measures the efficiency of a company. It measures the associated costs versus production and profits. Basically every company wants to produce a high quality product with as few resources as possible. Operating efficiency is best described as producing the same amount with less resources. This can be measured in a few ways:

  • Operating margin
  • Operating ratio

35.1 Operating margin

Measures how much profit a company makes for each $1 of sales after paying variable costs (production costs, wages) but before taxes.

35.1.1 How to use operating margin

An operating margin of 20% means the company generated $0,2 for each $1 in revenue (before taxes).

  • Higher is better
  • Above 15% is considered healthy (always use industry average)
  • Can be very different between industries
  • Can be used to compare companies

35.1.2 Why do investors use operating margin in their analysis

To determine how much profit a company is making from it’s core business.

35.1.3 hings to be aware of

  • Only compare with other companies in the same industry
  • Can be calculated in different ways

35.1.4 How to calculate operating margin

  • Operating margin = operating earnings / revenue

35.1.5 Real life example

A real life example of Tesla. You need the following data to determine operating margin:

  • Operating margin = operating earnings / revenue
  • $2,464,000 / $16,934,000 = 0.145 *100% = 14.5%
Penke

Tesla generated $0,145 for each $1 of sales (before taxes).

Operating margin is used to calculate how much profit a company makes after variable costs of production but before paying interest and taxes. Some variable costs examples are wages, raw materials, packaging, and transaction fees. The amount of variable costs is different for each company and industry. In general, a higher operating margin is better as this implicates that a company is running efficiently. 

For investors, a higher operating margin is a good sign. Although you should always look at operating margin in the long term. If operating margin is fluctuating over the years this might be a sign that things are not running efficiently enough. It’s a way to check how much profit a company is making from its core business.

Operation earnings can be calculated in multiple ways:

  • Operation earnings = EBIT - non operating income + non operating expense
  • Operation earnings = Gross profit - operating expense - depreciation and amortisation
  • Operation earnings =  Total revenue - COGS (costs of goods sold) - indirect costs

Don’t worry about all the terms, I already calculated the operation margin for every company. Just use the search bar at the top of this page and fill in the ticker symbol of the stock you want to check. A healthy operating margin is above 15%. Always compare operating margin between the same type of companies and industries.

35.2 Operating ratio

 Measures how efficient the company is creating its products or services while keeping operating costs low.

If the operating ratio is below 1 that means the company is making money. The lower the operating ratio, the more efficient the company.

35.2.1 How to use operating ratio

An operation ratio of 0.5 means that the operating costs are $0,5 for each $1 in net sales.

  • Lower is better
  • Below 1 is considered healthy (always use industry average)
  • Can be very different between industries
  • Can be used to compare companies

35.2.2 Why do investors use operating ratio in their analysis

Shows if costs of creating products and or services is increasing or decreasing. The lower the operating ratio, the more efficient the company is creating products and services. 

35.2.3 Things to be aware of

  • Only compare with other companies in the same industry
  • You need COGS (Cost Of Goods Sold) to calculate operating ratio which is not always shown in the income statement
  • Does not consider debt

The three steps every investor should look at:

  • What is the current net operating ratio?
  • What is the long term trend?
  • How does it compare to the industry?

35.2.4 How to calculate operating ratio

  • Operating ratio = Operating expenses plus COGS \ Net sales]

The operating ratio measures the efficiency of a company at keeping low costs while generating profits from sales. It compares the total operating expenses to the net amount of sales. The total operating expenses exists of:

  • COGS (materials, labour, rent of facility, repairs) 
  • Operating expenses (legal fees, marketing, wages, rent, maintenance/repairs)

Operating expenses are all the costs the company makes that are not directly tied to the production of the service or product.  Where COGS are costs that are directly tied to the production of a product or service.

Do note that COGS is not always available in the income statement. Some companies include COGS in the operating expenses while others list COGS separately. To make it even more confusing, COGS is also known as “costs of sales” and costs of sales is the same as costs of revenue.

The operating ratio tells you how efficient the company is creating its products or services while keeping prices low. In this case, a lower ratio is better. Higher or rising operating ratios might tell you that costs are rising while sales are not improving or staying the same.

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Key Concepts:

  • Operating efficiency measures the efficiency of a company.
  • Efficiency means producing the same amount with less resources.
  • Operating margin is used to calculate how much profit a company makes after variable costs of production but before paying interest and taxes.
  • The operating ratio measures the efficiency of a company at keeping low costs while generating profits from sales.
Penke

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