Operating Ratio: Definition, Calculation & Importance

The operating ratio is a measure of efficiency that is used by management to determine day-to-day operational performance. This metric compares operating expenses, also known as OPEX, to net sales. The desired outcome is a lower ratio of operating expenses.

The operating ratio metric assesses how effective an organization or team is at maintaining a lower cost of operations while generating a certain level of sales and revenue. A smaller ratio indicates the organization is generating more revenue as compared to total expendituresFixed and Variable CostsCost is something that can be classified in several ways depending on its nature. One of the most popular methods is classification according.

Interpreting the Operating Ratio

An investment analyst uses a variety of tools to determine how an organization is performing. Since it places emphasis on a company’s core business activities, the operating ratio is an excellent tool to describe the company’s performance and level of efficiency. Together with return on company sales and return on equity, the operating ratio helps analysts measure working efficiency. The ratio helps to analyze trends and track performance over a certain period.

If the ratio is increasing, the organization is not working as efficiently. In such a case, operating costs are going up relative to revenue or sales. On the other hand, if the ratio is decreasing, it implies the company is effectively cutting back on its expenses while creating more sales.

An organization may be forced to implement cost control measures to improve its margins if it experiences a persistently increasing operating ratio. Decreasing operating cost relative to sales revenue is noted as a positive sign.

Components of the Operating Ratio

Operating expenses encompass all costs except interest paymentsInterest ExpenseInterest expense arises out of a company that finances through debt or capital leases. Interest is found in the income statement, but can also and taxes. Organizations do not factor in non-operating expenses, such as exchange rate costs, into the operating ratio, as these are extra expenses unrelated to core business activities.

Operating expenses include overheads such as general sales or administrative costs. Examples of overhead include expenses accrued because of owning a corporate office since, although it is necessary, it is not linked to the production process. Operating expenses include:

• Legal and accounting fees
• Banking charges
• Marketing or sales costs
• Office costs
• Wages or salaries

In some instances, operating costs include the cost of goods sold (COGS). Such expenses are directly related to the production process. That said, some companies prefer to keep operating costs and direct production costs separately. The direct product costs can include:

• Material costs
• Labor cost
• Wages and benefits for production workers
• Machine repair and maintenance costs

Total sales or revenue usually appears at the top of an income statementIncome StatementThe Income Statement is one of a company's core financial statements that shows their profit and loss over a period of time. The profit or as the sum total that an organization generates.

Shortcomings of the Operating Ratio Metric

One drawback of the operating ratio is its disregard for debt. A number of organizations accumulate a huge amount of debt. This usually translates to paying high interest expenses, which are never included in the figures used to work out the operating ratio. Two organizations may report similar operating ratios, but have significantly different amounts of debt. Therefore, debt rates should also be assessed when valuing a company.

As is the case with most other financial metrics, it is important to monitor the operating ratio over a number of reporting periods to find out whether there is a noticeable trend.

Investors should monitor a company’s costs for changes while also reviewing these results against profit and revenue. In addition, an organization’s operating ratio should be compared with that of similar companies in the same industry to get a better sense of how positive or negative the ratio is.

Final Word

Any investor looking to buy a stake in a company would do well to consider its operating ratio. However, it should be viewed with caution because most companies do not include debts in the calculation of the ratio.

Related Readings

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To keep advancing your career, the additional CFI resources below will be useful:

• Capital ExpendituresCapital ExpendituresCapital expenditures refer to funds that are used by a company for the purchase, improvement, or maintenance of long-term assets to improve
• Cost of Goods Sold (COGS)Cost of Goods Sold (COGS)Cost of Goods Sold (COGS) measures the “direct cost” incurred in the production of any goods or services. It includes material cost, direct
• Efficiency RatiosEfficiency RatiosEfficiency ratios are metrics that are used in analyzing a company's ability to effectively employ its resources, such as capital and assets,
• Leverage RatiosLeverage RatiosA leverage ratio indicates the level of debt incurred by a business entity against several other accounts in its balance sheet, income statement, or cash flow statement. Excel template