Operating Ratio Meaning
The operating ratio refers to a metric used by a company to determine how efficient a company’s management is at keeping operating costs low while at the same time generating revenues or sales by comparing the total operating expenses of a company to that of its net sales.
The total operating expenses consist of two components, the cost of goods soldCost Of Goods SoldThe Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. and operating expensesOperating ExpensesOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit..
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- Operating expenses generally include accounting and legal fees, bank charges, sales and marketing costs, office supply costs, salary and wages, repair and maintenance costs, and non-capitalized R&D expenses.
- The cost of goods sold includes direct material costsDirect Material CostsDirect Material Cost is the total cost incurred by the company in purchasing the raw material along with the cost of other components including packaging, freight and storage costs, taxes, etc. that are related directly to the manufacturing and production of various products of the company., plant rent, direct labor, repair costs, etc.
Interpretation of Operating Ratio
It is arrived at by dividing the sum of operating expenses and the cost of goods sold by the net sales.
Operating ratio =(Operating Expenses+Cost of Goods Sold)/ Net Sales.
A higher ratio would indicate that expenses are more than the company’s ability to generate sufficient revenue and may be considered inefficient. Similarly, a relatively low ratio would be considered a good sign as the company’s expenses are less than that of its revenue.
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Example of Operating Ratio
Let us calculate the operating ratioCalculate The Operating RatioThe operating ratio formula is the ratio of a company's operating expenses to net sales, where operating expenses include administrative costs, selling and distribution costs, cost of goods sold, salary, rent, other labour costs, depreciation, and so on. Operating ratio = Operating expenses/Net sales* 100. of GE for the year 2018. The details are provided in the snapshot.
Source: GE Annual Report
Use the following data –
- Cost of Good Sold: $63116
- Total Revenue: $121615
- Cost of Services Sold: $29555
- Selling, General and Administrative Expenses: $18111
- Other Costs and Expenses: $464
Cost of goods sold= Cost of goods and cost of services (63116+29555)= 92671
- Total operating expenses= Selling, general and administrative expensesSelling, General And Administrative ExpensesSelling, general and administrative (SG&A) expense includes all the expenses incurred in the selling of the products of the company whether direct or indirect along with the entire general and the administrative expenses during an accounting period under consideration such as advertisement expenses, sales promotion expenses, marketing salaries, etc. (18111)+ Other costs and expenses (464)= 18575
- Net Sales = 121615
Therefore, the calculation can be done as follows –
Operating Ratio = (Operating Expenses+Cost of Goods Sold)/Net Sales
- = (18575+92761)/121615
Advantages of Operating Ratio
- Financial Metric to Assess Business: It serves as an essential facilitator of ratio analysisRatio AnalysisRatio analysis is the quantitative interpretation of the company's financial performance. It provides valuable information about the organization's profitability, solvency, operational efficiency and liquidity positions as represented by the financial statements. by comparing the business’s expenses to that of the revenues and thus serves as a necessary tool of financial assessment in understanding the company’s health.
- Facilitates Time Series Analysis: By serving as a metric to gauge the operational ability of a company, this ratio also tends to facilitate time series analysis over periods of the same company. This way, one can understand if a company fared better in this particular metric in the previous years or did well in the current year. This way, a time series analysis of a company can be undertaken over a time frame.
- Facilitates Cross-Sectional Comparison: This metric also helps in intercompany comparison by helping to look at the same ratio of different companies. The metric can also be compared against the industry benchmark to gauge and understand if the performance is in line with the industry and peers and if there is room for growth and performance improvement.
- Serves as an Indicator to Show Efficiency of Management: By comparing the company’s operating expenses with that of the turnover, one can understand if the company is efficient in managing its expenses. A lower ratio is a good sign, whereas an increasing ratio tends to act as a red signal as it indicates the expenses are increasing over time, and it is imperative to keep a tab on the same.
Disadvantages of Operating Ratio
- Cannot be considered in Isolation: It becomes essential to note that just by looking at this measure, one cannot judge the total health of the business. One must also look at profitability activity and leverage ratioLeverage RatioDebt-to-equity, debt-to-capital, debt-to-assets, and debt-to-EBITDA are examples of leverage ratios that are used to determine how much debt a company has taken out against its assets or equity. to gauge and better understand the business.
- Cannot Compare with other Industries: One disadvantage of such a ratio is that one cannot compare the ratio with firms doing business in other industries as that may not be a suitable benchmark. One has to look into similar businesses to facilitate comparison and better understand the business when looked upon relatively.
- Do not Consider Debt: A company may have a massive amount of debt, and those interest payments are usually not part of the business’s operating expenses. Hence it will not be of much use if (one were to study this ratio in isolation). One needs a holistic view by considering the other ratios usually used in financial statement analysis.
- Requires Relative Judgment: One needs comparative data to gauge and understand this ratio and thereby judge the performance of the business by looking at other relative sources of data as this ratio itself cannot be studied in isolation.
- Few Components not Considered: It does not go on to consider some components such as debt, and the subsequent interest payments do not form part of the numerator as a part of the operating expenses. Hence the analysis may tend to get skewed to such an extent.
The operating ratio stands to serve as an excellent metric. It helps the management and analysts understand if the company is efficient enough to manage all of its expenses against its total turnover. Similar to financial statement analysis by using other ratios, this measure, too, helps in understanding time-series and cross-sectional analysis by comparing a company over time and against that itself and even its peers.
Though this metric lacks in terms of the scope that it cannot be studied in isolation and may also tend to miss out on specific components that do not consider as that interest payment on debts, the analyst has to note and be mindful of the same. However, over the years, this metric does have, to its credit, the commendable job of having to serve as a classic example to gauge the efficiency of the management by understanding how it manages expenses over that of its sales.
This article has been a guide to the operating ratio and its meaning. Here we discuss how to interpret operating ratios and examples, advantages, and disadvantages. You can learn more about financing from the following articles –