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
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.