What is Working Ratio?
The working ratio represents the financial sustainability of the company by measuring the capacity of a company to recover operating expenses using its annual gross revenue. The operating expenses does include expenses such as depreciation and also excludes any finance expenses such as interest on debts.
The lower the ratio, the higher the level of financial sustainability since it would mean that fewer revenues are being used to meet the expenses. However, the ideal working ratio is one. A company that is not able to cover the operating expenses that it incurs on the business activities can’t survive for long.
To calculate the working ratio, annual operating expenses are divided by annual gross revenue. However, depreciation is to be excluded from the annual operating expenses.
Examples of Working Ratio
Let us understand its calculation with the help of the following example:
Now, let us calculate the working ratio using the above data.
Here the working ratio is 0.40, which is favorable for the company since it can recover its annual operating expenses from the annual gross revenue. The company is financially sustainable as less portion of revenues is going towards the recovery of expenses.
The working ratio is important for assessing the financial sustainability of the company. It reflects what extent the company’s revenue can cover its operating expenses. A ratio below one indicates that the company can recover its operating expenses through its gross revenue. On the contrary, a ratio above one indicates that the company cannot meet its operating expenses through its gross revenues. A ratio equivalent to one shows an equilibrium position.
Companies need to have a ratio either equal to or less than one. This would mean that they can recover their annual operating expenses from the income generated through gross revenues.
It is an important financial ratioFinancial RatioFinancial ratios are indications of a company's financial performance. There are several forms of financial ratios that indicate the company's results, financial risks, and operational efficiency, such as the liquidity ratio, asset turnover ratio, operating profitability ratios, business risk ratios, financial risk ratio, stability ratios, and so on. and is helpful for analysis due to the following reasons:
- It helps the finance managers to determine the financial sustainability of the company by comparing the annual operating expenses against the gross annual revenue.
- Based on this ratio, the management can take action to manage its cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. .
- The management can also decide as to what steps are to be taken for the reduction of unnecessary expenses and the increase in sales of the company.
There are many limitations. Some of them are listed below for your reference:
- The ratio uses gross revenue in the denominator instead of net revenueNet RevenueNet revenue refers to a company's sales realization acquired after deducting all the directly related selling expenses such as discount, return and other such costs from the gross sales revenue it generated.. This means that the ratio doesn’t consider important factors relating to revenue, such as sales returns and any allowances.
- There is no consideration of changes that are expected to occur in operating expenses in the coming years, as no effect for inflation is taken into account.
- Financing expenses are excluded from the calculation of working ratio though they have to borne by the company and affect its sustainability.
- The ratio suggests the company’s ability to meet its operating expenses from the gross revenue. However, it doesn’t take into account that all expenses and revenues might not affect cash flows.
The working ratio helps to determine the ability of the company to meet its annual operating expenses from its annual gross revenue. It determines the financial sustainability of the company. However, this ratio alone doesn’t give us fruitful results. Other financial ratios shall also be considered for reaching a meaningful conclusion; otherwise, the conclusion arrived might not be an accurate one.
This has been a guide to what is Working Ratio and its definition. Here we discuss its calculations along with formula, examples, advantages, and disadvantages. You may learn more about financing from the following articles –