Can You Have a Negative Operating Profit Margin Ratio?
A company's operating profit margin ratio measures its operating profit as a percentage of its sales revenue. It is one of the most significant financial ratios for insight into a company's performance. Generally speaking, the higher the operating margin, the better it is for the company.
However, if a company experiences rough times, they may experience a negative operating margin. A negative profit margin ratio is not the be-all and end-all, yet company management must find ways to continue operating and correct the issues before long-term issues arise.
The profit earned from business operations prior to non-operating expenses – such as interest owed on debt and taxes – is referred to as a company's operating profit.
The company's operating profit can be found by subtracting the cost of goods sold and operating expenses – such as payroll and rent – from the company's total sales.
For example, if a small business has $500,000 in sales one year, but also paid $200,000 to acquire the goods sold and spent $100,000 on operating expenses, the company's operating profit would be $200,000. However, if that same company paid $300,000 to acquire the goods sold and spent $250,000 on operating expenses, it would have an operating profit of -$50,000.
A company's profit margin ratio is a percentage that equals its operating profit or loss for a particular period divided by its total revenue in that same period.
In the first scenario above, you could use the operating profit margin ratio formula to find the company's operating profit margin by dividing $200,000 by $500,000 to get 0.4, or 40%.
In the second scenario above, because the operating profit is negative, the profit margin percentage will be negative.
Dividing -$50,000 by $500,000 to get -0.1, or -10%. This -10% means the company's net loss for the period equals 10% of their sales, or, for every $1 made in sales, they lost 10 cents in operations. If a company's operating profit margin ratio is positive, the higher it is, the better – if it has a negative profit margin ratio, the closer it is to zero, the better.
Although they try to avoid it, it is not uncommon for businesses to experience periods of negative profit margins. There are two broad reasons that cause this to happen: an increase in costs or a decline in sales. More often than not, it is a combination of both.
If a company sells products, they have to consider the cost of raw materials needed in production. If the price of those raw materials increases, there is a chance it could cause the cost of production to exceed its selling price. In most cases, a company would increase the price of the product to account for this cost increase, but there may come scenarios where they are in contracts that keep prices fixed.
For example, an electronics company signs a contract with a school to sell them 1,000 handheld devices for $100,000 over the next five years. If it cost the electronics company $80 to make each handheld device at the time the contract was signed, but those costs increase by $25 for whatever reason, the profit margin would turn out to be negative.
A sudden increase in labor cost can also lead to negative profit margins. The primary reason for increased labor costs is the increased need for productivity from workers, which means either paying employees for overtime – which is often 1.5 times the normal rate for hourly employees – or hiring additional workers. Companies may have to do this when they are approaching times of unexpected demand increases, or when they are backed up in fulfilling orders and need the extra hands.
The overlying reason for a decrease in revenue is, of course, a decline in sales, but this decline is often influenced by specific factors that a business needs to pinpoint so they can address the issue.
For example, a poor marketing strategy for new product launches may be causing lackluster enthusiasm among consumers and stagnating demand.
Not only would this keep revenue low from the lack of sales, but it would also cause the business to incur other costs associated with storing inventory. A business may also be aiming their marketing efforts at the wrong type of consumers and wasting company resources.
Factors outside of the company's control, such as increased competitors in the marketplace, can also drive its revenue down. Increased competition means customers have more options, and there are many factors that determine who they decide to give their business to.
For example, if a competitor has similar prices but is located closer to customers, they are likely to grab some of the sales a company would have otherwise made. If location is not a factor, a company may be forced to cut its prices to remain competitive, subsequently decreasing its revenues (assuming price remained the same).
By reviewing its revenues and expenses over specific periods, a company can identify whether the negative operating margins are a one-off or the result of problems with its business model and cost structure.
It is one thing for a botched marketing campaign to cause a business to lose money during a specific quarter. It is a bigger issue when the losses are consistent when other factors are changed.
A company may need to add new income streams that can supplement unprofitable ventures or products, or do away with those altogether. By analyzing the operating profit margins of competitors in its industry, a company can determine what to aim for.
If a company is experiencing negative operating profit margins, they can only survive as long as their cash reserves will allow. If they begin to run out of cash on hand, they may have to sell assets in order to cover their expenses and remain in operation. If selling assets is not a viable option for whatever reason, seeking outside financing may be the only option left.
Most business loans generally require that a company shows it is in good financial conditions, so chances are a company would have to go through unsecured means like credit cards and other credit lines to get the needed funds.
It is not uncommon for a new business to have a negative profit margin ratio as it focuses its attention and financial resources on trying to acquire new customers and gain market share. Sales are likely to be low for new businesses, but fixed expenses like rent will be the same regardless.
A company may experience negative profit margins during these early periods before sales are sufficient to cover these expenses.
New businesses may also incur higher marketing costs early on as they attempt to attract and retain customers. Companies may choose to offer special promotions and discounts that incentivize potential customers to try their product or service.