What Is the Working Ratio?
The working ratio measures a company's ability to recover operating costs from annual revenue. It is calculated by taking total annual expenses, excluding depreciation and debt-related expenses, and dividing it by the annual gross income:
Working Ratio=Annual Gross IncomeTAE−(Depreciation+Debt Expenses)where:TAE=total annual expenses
- The working ratio measures a company's ability to recover operating costs from annual revenue.
- It is calculated by taking total annual expenses, excluding depreciation and debt-related expenses, and dividing it by the annual gross income.
- The lower the ratio, the more profitable a company is.
- A working ratio below one implies the company is able to recover operating expenses, whereas a ratio above one reflects its inability to do so.
Understanding the Working Ratio
The working ratio is tasked with gauging a company's financial sustainability. All businesses will incur costs to operate and generate sales, ranging from rent, equipment, and inventory charges, to marketing, staff wages, and insurance. Those who are unable to consistently clear these expenses and pay their bills aren’t running a viable business and probably won’t be around for long.
The working ratio’s job is to inform us if this is the case and to what degree. The threshold for this ratio is one. Any number below that indicates that the company is able to recover operating costs—lower figures are synonymous with expenses eating up a small chunk of gross income. Conversely, a ratio above one implies that the company isn’t breaking even and generating enough money to cover its costs.
A ratio of one means a company’s annual gross income is equal to its total expenditure, so anything below that implies the company is able to recover operating costs, whereas anything above reflects its inability to do so.
Example of the Working Ratio
XYZ Inc. has been making widgets since the 1900s and is seen in the industry as a somewhat antiquated brand. XYZ hasn't spent very much money overhauling its machinery over the years and is still using old technology to manufacture its end product.
Management argues that not upgrading to the latest model has saved it money that can be better spent elsewhere. The problem is the equipment it uses is power-intensive, expensive to run and maintain, relative to newer versions, meaning that persisting with the old technology actually works out to be more pricey over the long-run.
To make matters worse, XYZ is also losing market share every year to its more modern competitors. Sales are falling and costs are rising, leading to a progressively higher working ratio. Recently it rose above one, the tipping point, and analysts fear it will continue to climb, putting the business in danger of reneging on payments, unless drastic changes are soon made to slash costs and catch up with the competition.
Limitations of the Working Ratio
The working ratio is not perfect and cannot be fully relied on to determine a company’s financial health and ability to cover expenses with the money it brings in.
One issue is that it does not take financing costs into consideration. This oversight can lead to misleading results, particularly as most companies borrow money to fund growth and are required to pay back these loans, together with interest, punctually.
The ratio also does not account for projected changes in operating expenses. In some industries, operating costs have a tendency to fluctuate from year to year and in certain periods can be uncharacteristically low or high for a good reason.
If the company has cash tucked away to bankroll extra costs, and is poised to generate extra revenues off them in the future, its current high working ratio shouldn’t necessarily be a cause for alarm.
When applying ratios, investors are advised to not always take the number that is generated at face value. Context is important and further digging to see if there is a reasonable explanation behind unusual results is a must.
In general, every ratio tends to overlook something important. That ultimately means that it’s usually necessary to consult several at the same time to get an accurate, more complete picture of how the subject is faring. The more information that is taken into consideration, the better chance investors have at making more informed decisions about where to allocate their money.