Loading the player...

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.

Formula for calculating the operating ratio.

BREAKING DOWN 'Operating Ratio'

Investment analysts have many ways of analyzing company performance. Because it concentrates on core business activities, one of the most popular ways to analyze performance is by evaluating the operating ratio. Along with return on assets and return on equity, it is often used to measure a company's operational efficiency. It is useful 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 viewed as a negative sign, as this indicates that operating expenses are growing larger or net sales are growing smaller. In this case, a company may need to implement cost controls for margin improvement. An operating ratio that is decreasing is viewed as a positive sign, as it indicates that operating expenses are becoming an increasingly a smaller percentage of net sales.

Operating Ratio Calculation

The operating ratio is calculated by dividing operating expenses by net sales. Operating expenses are essentially all expenses except taxes and interest payments. 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 net 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 referred to as the 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 may indicate inefficiency, and vice versa. That said, some companies have taken on a great deal of debt, meaning they are committed to paying large interest payments which are not included in the operating expenses figure of 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. Finally, as with all ratios, it should be used as part of a full ratio analysis, rather than in isolation.

RELATED TERMS
  1. Accounting Ratio

    Accounting ratios, also known as financial ratios, are used to ...
  2. Efficiency Ratio

    The efficiency ratio is used to analyze how well a company utilizes ...
  3. Current Ratio

    The current ratio is a liquidity ratio that measures a company's ...
  4. Debt Ratio

    The debt ratio is a financial ratio that measures the extent ...
  5. Leverage Ratio

    A leverage ratio is any one of several financial measurements ...
  6. Interest Coverage Ratio

    The interest coverage ratio is a debt ratio and profitability ...
Related Articles
  1. Investing

    Ratio Analysis

    Ratio analysis is the use of quantitative analysis of financial information in a company’s financial statements. The analysis is done by comparing line items in a company’s financial ...
  2. Investing

    ETF Gross vs. Net Expense Ratios: How They Differ

    If you're going to invest in ETFs, you should know the intricacies of expense ratios.
  3. Investing

    Key Financial Ratios to Analyze Tech Companies

    Understand the technology industry and the companies that operate in it. Learn about the key financial ratios used to analyze tech companies.
  4. Investing

    Understanding Leverage Ratios

    Large amounts of debt can cause businesses to become less competitive and, in some cases, lead to default. To lower their risk, investors use a variety of leverage ratios - including the debt, ...
  5. Investing

    Key Financial Ratios for Retail Companies

    Using the following liquidity, profitability and debt ratios, an investor can gather deeper knowledge of a retail company's short-term and long-term outlook.
  6. Investing

    Payout Ratio vs. Retention Ratio: When to Use Which

    The payback ratio and retention ratio collect different information and are useful in different situations.
  7. Investing

    Key Financial Ratios to Analyze The Healthcare Industry

    Examine the health care sector and learn about significant financial ratios used by investors and analysts to evaluate health care companies.
  8. Investing

    Analyzing AT&T's Debt Ratios in 2016 (T)

    Learn about AT&T Inc. and its key debt ratios, such as the debt-to-equity ratio, interest coverage ratio and cash flow-to-debt ratio.
  9. Investing

    What Is the Best Measure of a Company's Financial Health?

    Discover the single best financial metric that investors can use for determining the financial health and long-term sustainability of a company.
RELATED FAQS
  1. What is the difference between efficiency ratios and profitability ratios?

    Learn about efficiency and profitability ratios, what these ratios measure and the main difference between efficiency and ... Read Answer >>
  2. What is the expense ratio in the insurance industry?

    Understand the two different methods of calculating expense ratio and find out how it can be used to compare insurance companies ... Read Answer >>
  3. If a company has a high debt to capital ratio, what else should I look at before ...

    Learn about some of the financial leverage and profitability ratios that investors can analyze to supplement examining the ... Read Answer >>
  4. Why do shareholders need financial statements?

    Discover the importance of a company's financial statements for stock shareholders in evaluating their equity investment ... Read Answer >>
  5. What are financial risk ratios and how are they used to measure risk?

    Explore some of the primary financial risk ratios that investors and analysts commonly use to evaluate a company's overall ... Read Answer >>
Trading Center