What is the 'Operating Ratio'
The operating ratio shows the efficiency of a company's management by comparing operating expense to net sales. The smaller the ratio, the greater the organization's ability to generate profit if revenues decrease. When using this ratio, however, investors should be aware that it doesn't take debt repayment or expansion into account.
BREAKING DOWN 'Operating Ratio'
Analysts have many ways of analyzing performance trends. One of the most popular, because it concentrates on core business activities, is the operating ratio. The operating ratio is viewed as a measure of operational efficiency. It is often used, along with return on assets and return on equity, to measure a company's efficient use of capital and managerial resources. Analysts also like to track the operating ratio over a period of time to identify trends in operational efficiency or inefficiency. An operating ratio that is going up is indicative of an inefficient operating environment that might need to implement cost controls for margin improvement. An operating ratio that is decreasing is indicative of an efficient operating environment in which operating expenses are increasingly a smaller percentage of sales.
Operating Ratio Calculation
The operating ratio is calculated by dividing operating expenses by sales. Operating expenses are essentially all expenses except taxes and interest. Occasionally, a company has non-operating expenses as well, which are also deducted. All of these line items are listed on the income statement. Companies must clearly state which expenses are operational and which are designated for other uses.
Operating Ratio Example
Assume company A has $100,000 in sales; $50,000 in total expenses, including $3,000 in taxes; and $7,000 in interest payments. In this scenario, the operating expense is calculated by deducting taxes and interest payments from total expenses. The result is $50,000 minus $7,000 minus $3,000, for an amount of $40,000. The operating ratio is therefore $40,000 divided by $100,000, or 40%. This means that 40% of company A's revenues are used for operating expenses. The total expense ratio is calculated as $50,000 divided by $100,000, or 50%. This also happens to be net income margin.
Points of Consideration
It is important to compare the operating ratio with other firms in the same industry. If a company has a higher operating ratio than its peer average, it a robust indication of inefficiency, and vice versa. That said, some companies have taken on a great deal of debt. More leverage translates into additional risk with higher interest payments, but this risk is not evident in the operating ratio. Two companies can have the same operating ratio with vastly different debt levels, so it is important to compare debt ratios before coming to any conclusions.