The operating ratio is a financial metric that assesses a company's management effectiveness in controlling operating costs. It is calculated by dividing the company's total operating expenses (OPEX) by its net sales revenue. A lower operating ratio indicates that a company is more efficient at generating revenue while keeping operating costs under control.
In this article, we examine the meaning of the operating ratio, check out the operating ratio formula and calculation and discuss what it can tell you. Let us begin by exploring what the operating ratio is.
What is the operating ratio?
The operating ratio compares the operating expenses (OPEX) incurred by a company during a given period with its net sales over the same period. This ratio tells you how much of a company’s sales go towards meeting its operating costs. Naturally, the lower the operating ratio is, the better.
A lower ratio means that the company is capable of keeping its operating expenses from exceeding a reasonable limit. This, in turn, reflects positively on the efficiency of the company’s management team.
Key takeaways
- The operating ratio is a measure that compares a company’s operating costs to its net revenue or sales over a given period.
- The operating ratio formula involves dividing the sum of the operating expenses and the cost of goods sold (COGS) by the net sales.
- A lower ratio is considered better because it indicates that the company has greater operational efficiency.
- Investors can compare the operating ratio over different periods to assess how a company’s operational efficiency has changed with time.
Formula of operating ratio
The operating ratio is calculated using the following formula:
Operating Ratio = (Operating Expenses + Cost of Goods Sold) / Net Sales
To calculate the operating ratio, you'll need to obtain the following information from a company's income statement:
- Total Cost of Goods Sold (COGS): This represents the direct costs associated with producing or acquiring the goods that the company sells.
- Total Operating Expenses: These are the ongoing expenses incurred in running the business, excluding cost of goods sold. Examples include rent, salaries, utilities, and marketing expenses.
By dividing the sum of operating expenses and cost of goods sold by the company's net sales revenue, you can determine the operating ratio, which provides valuable insights into the company's operational efficiency.
How to calculate the operating ratio
Here are the steps to calculate a company's operating ratio once you have gathered all the necessary information:
- Add operating expenses and cost of goods sold:
- Begin by summing the company's operating expenses and the cost of goods sold.
- If your company already has a combined figure for these expenses, you can skip this step.
- This total represents the overall cost of conducting business in India.
- Divide costs by net sales:
- Divide the total cost calculated in step 1 by the company's net sales revenue.
- This gives you the operating ratio, which will always be a value greater than zero and typically less than one.
- (Optional) Multiply by 100:
- If you prefer to express the operating ratio as a percentage, multiply the calculated ratio by 100.
- This can make the value easier to understand and interpret for Indian businesses.
Example:
If a company in India has operating expenses of Rs. 40,00,000 (Rupees Forty Lakhs), cost of goods sold of Rs. 57,00,000 (Rupees Fifty-Seven Lakhs), and net sales of Rs. 250,00,000 (Rupees Two Hundred Fifty Lakhs), its operating ratio would be calculated as follows:
- Step 1: Total costs = Rs. 40,00,000 (operating expenses) + Rs. 57,00,000 (cost of goods sold) = Rs. 97,00,000
- Step 2: Operating Ratio = Rs. 97,00,000 (total costs) / Rs. 250,00,000 (net sales) = 0.388
- Step 3: Operating Ratio (percentage) = 0.388 * 100 = 38.8%
How the operating ratio works?
When investors evaluate if a company is a potentially lucrative investment, they often limit their assessment to the valuation aspects. However, you should not stop with this element alone. You must also check the company’s operational efficiency to get a more comprehensive overview of its long-term profitability and stability.
Here is where the operating ratio can be useful. It tells you whether a company redirects most of its sales to meet the costs of running the business. If this is the case, the company’s prospects of profitability may be slim.
That said, many companies may have high operating ratios during the early stages of their growth. However, over time, the ratio should decrease as the company becomes more efficient at managing costs and increasing its revenue. This is why it is important to evaluate the ratio not just for one financial year, but to check its trajectory over the previous few years.
Components of the operating ratio
The operating ratio formula includes two key components. Let us check out the formula below before decoding what the components mean.
Operating ratio = Operating expenses ÷ Net sales
Sometimes, the ratio may be expressed as a percentage, in which case the operating ratio formula becomes:
Operating ratio = (Operating expenses ÷ Net sales) x 100
As you can see from the formulas shown above, the operating ratio typically uses two components. The numerator includes the operating costs incurred by a company to support its business. They are not directly related to production or service generation. Some common examples of operating expenses include rent, utility costs, office supply purchases, salaries, marketing and advertising expenses and repairs and maintenance.
Sometimes, the cost of goods sold (COGS) may be shown separately in a company’s books. In that case, the COGS must also be included in the numerator. This gives us a modified version of the operating ratio formula, as shown below:
Operating ratio = (Operating expenses + Cost of goods sold) ÷ Net sales
The second component in the formula is the net sales of a company. This is simply the gross or total sales, adjusted for returns, discounts, commissions and other such reductions. Ultimately, it reflects the amount actually earned from a company’s sales.
Importance of operating ratio
Operational efficiency is assessed using the operating ratio, which compares a company’s operating costs to its operating revenue. This ratio shows what portion of revenue is consumed by expenses. It is closely linked to the operating profit ratio, as both are complementary—when the operating ratio decreases, the operating profit ratio increases. These ratios are expressed as percentages for clarity and comparison. A lower operating ratio indicates better efficiency and cost control. By analyzing individual components of operating costs in detail, management can identify specific areas that need improvement and take corrective actions to enhance overall performance and profitability.
Interpreting the operating ratio
An investment analyst utilizes various tools to evaluate a company's performance. The operating ratio, which emphasizes core business activities, provides valuable insights into a company's operational efficiency. In conjunction with metrics like return on company sales and return on equity, the operating ratio assists analysts in measuring overall working efficiency. By analyzing trends in the operating ratio over time, analysts can track the company's performance and identify areas for improvement. A rising operating ratio may indicate declining efficiency, suggesting a need for the company to implement cost control measures to improve margins. Conversely, a decreasing operating ratio is generally viewed as a positive sign, implying that the company is effectively controlling costs while generating revenue.
Advantages of operating ratio
A financial metric used to assess a business plays an important role in ratio analysis by comparing a company’s expenses with its revenue. This comparison provides valuable insight into the organisation’s financial position and overall health. It helps stakeholders understand how effectively the business is generating income relative to its costs, making it a key tool in financial evaluation.
This metric also supports time series analysis, allowing performance to be tracked over different periods within the same company. By examining changes in the ratio across years, it becomes easier to identify trends and determine whether the company’s operational performance has improved or declined. Such analysis helps in making informed decisions based on historical performance.
In addition, the metric enables cross-sectional comparison between different companies. By comparing the same ratio across organisations or against industry benchmarks, one can evaluate whether a company is performing in line with its competitors. This also highlights areas where the business may need to improve in order to remain competitive and achieve growth.
Furthermore, the ratio acts as an indicator of management efficiency. By analysing the relationship between operating expenses and turnover, it becomes clear how well the company controls its costs. A lower ratio generally indicates efficient management, while a rising ratio may signal increasing expenses. This serves as a warning that cost control measures may be needed to maintain financial stability.
What does the operating ratio tell you?
The operating ratio gives you crucial insights into how a company manages its costs and aims for efficiency in its operations. In simpler terms, it tells you how well a company controls its operating expenses and/or increases its revenue. A low value of the operating ratio means that only a small portion of the company’s sales go towards meeting its operating costs.
This means the entity is capable of keeping its costs low while generating high sales revenue — which directly translates to increased profitability. You can use the operating ratio to compare different companies within the same industry. This will tell you which companies are better at managing their expenses.
You can also evaluate this ratio for the same company over different years to assess if its operational efficiency has improved. An increasing operating ratio can be a red flag as it indicates rising expenses, reducing revenues, or both.
Example of the operating ratio
We have seen the meaning of the operating ratio, its formula and its components. Now, let us discuss a hypothetical example to understand how you can calculate and interpret this ratio.
Say a company has the following financial details in a given year:
- Operating expenses: Rs. 2,00,000
- Cost of goods sold: Rs. 1,50,000
- Net sales: Rs. 8,70,000
Plugging these values into the operating ratio formula, this is what we get.
Operating ratio:
= (Operating expenses + Cost of goods sold) ÷ Net sales
= (Rs. 2,00,000 + Rs. 1,50,000) ÷ Rs. 8,70,000
= Rs. 3,50,000 ÷ Rs. 8,70,000
= 40.23%
The ratio indicates that around 40% of the company’s sales are used to meet its operating costs. Whether or not this is normal depends on the company’s historical operating ratios, the industry average and other factors.
What are the uses of operating ratios?
- Operating ratios are widely used by stock analysts and investors to evaluate profitability, efficiency, valuation, management performance, and potential risks within a business.
- A primary use is to assess profitability. The ratio shows how much revenue remains after covering operating costs. A lower ratio suggests stronger profit margins, while a higher ratio indicates weaker profitability.
- Comparing operating ratios over time helps identify whether profit margins are improving or declining.
- Operating ratios also measure efficiency by showing how well a company controls its expenses relative to revenue. Falling ratios indicate better efficiency, whereas rising ratios may signal waste or poor cost control.
- Comparing ratios with industry peers provides insight into how efficiently a company performs relative to competitors.
- These ratios are important in valuation models, such as discounted cash flow analysis, as they help estimate future costs, margins, and profits. Stable or improving ratios often support higher valuations.
- Operating ratios reflect management decisions, making them a useful tool for evaluating leadership performance. Consistent or improving ratios suggest effective management.
- Sudden changes in the ratio may highlight underlying issues, such as operational disruptions, legal costs, or restructuring activities.
- When calculated using assets instead of revenue, operating ratios show how effectively a company uses its resources, indicating capital efficiency.
- Investors use operating ratios to form expectations about future stock performance, with improving ratios indicating positive prospects.
- They are also used as screening tools to identify potential investment opportunities with strong financial indicators.
- Detailed analysis of operating ratios helps investors understand business performance and assess potential risks before investing.
What is a good operating ratio?
The operating ratio is an important metric but has certain limitations. Firstly, it doesn't fully account for the impact of operating leverage. Companies with high fixed costs may see a declining operating ratio during periods of strong sales growth, not necessarily due to improved management efficiency but rather due to the favorable impact of fixed costs on profitability. Secondly, comparisons of operating ratios across companies are only meaningful when made within a peer group of similar size, industry, and maturity. Finally, while a declining operating ratio can signal potential efficiency improvements, further analysis is required to determine the root cause of this change.
A lower operating ratio generally suggests that a company is more efficient at generating profits. However, this measure has limitations. One key issue is that it does not account for operating leverage. For example, a company with high operating leverage, meaning it has more fixed costs than variable costs, may show improved ratios simply due to increased sales. As sales grow, fixed costs are spread over a larger revenue base, reducing the proportion of operating expenses. This improvement does not necessarily mean that management has become more efficient.
Additionally, comparisons with other companies are only meaningful when those companies are similar in size, industry, and stage of development. When analysing a company’s performance over time, the operating ratio can highlight potential efficiency gains, but further analysis is needed to understand the reasons behind these changes. Therefore, the operating ratio is best used as an initial analytical tool to identify trends rather than as a standalone measure for decision-making.
What does increasing the operating ratio mean?
An increasing operating ratio shows that a company’s costs of running its core activities are rising faster than the revenue it earns from sales. Key operating expenses typically include the cost of goods sold, sales and marketing, research and development, administrative costs, and depreciation.
When the operating ratio rises, it means that a larger share of revenue is being used to cover operating expenses instead of contributing to profit. Put simply, the business is becoming more expensive to run compared with the income it generates.
For investors, this trend is concerning. It indicates that the company is becoming less efficient at turning revenue into profit. As efficiency declines, profit margins and overall earnings come under pressure, which can negatively affect the company’s share price.
There are several reasons why an operating ratio may increase. These include higher raw material or input costs, rising labour expenses, increased spending on research and development, and greater marketing costs to boost sales. Expansion activities or acquisitions can also add to expenses. In addition, outdated systems, poor management decisions, or strong competition within the industry can drive up operating costs and reduce efficiency.
How do you reduce the operating ratio?
The most straightforward way for a company to improve its operating ratio is to increase sales revenue while keeping costs under control. When revenue grows, expenses are spread across a larger base of sales, which reduces the operating ratio. Businesses can achieve this by selling more products, increasing prices, or combining both approaches. Expanding sales volume involves attracting new customers and encouraging existing ones to purchase more frequently. Price increases are more effective when a company has strong pricing power, supported by brand strength, product uniqueness, or a favourable market position.
That said, pricing decisions must be made carefully to avoid reducing demand. Companies should avoid taking excessive risks or compromising profit margins in the pursuit of growth. Sustainable and profitable growth is essential, as unprofitable expansion can negatively affect investor confidence and share prices. Additionally, businesses must ensure they have the capacity and resources to handle increased demand; otherwise, growth may create inefficiencies that worsen the operating ratio.
Variable operating costs change in line with production levels. As output rises, these costs increase, and they fall when production declines. Common examples include raw materials, shipping, sales commissions, and hourly wages for production staff. Companies can lower variable costs per unit by negotiating better terms with suppliers, improving operational efficiency, and adopting automation to boost productivity. Reducing these costs improves profit margins and supports a healthier operating ratio.
However, a decline in variable costs caused by reduced production does not improve the operating ratio. Stable or growing sales volumes are necessary, as falling revenue makes it harder to cover fixed costs effectively.
Limitations of the operating ratio
The operating ratio can be beneficial to investors and analysts in many ways. However, it has some limitations that you should be mindful of. They include:
- Exclusion of debt: This ratio does not include a company’s debt. So, it may offer only a partial view of profitability. For instance, a company may have a low operating ratio, leading you to think it is profitable. But if its debts are significant, it may still record low profits.
- Not insightful as a standalone metric: The operating ratio may not tell you much as a standalone metric. To understand if the ratio is high or low, you need to compare it to the company’s historical operating ratios. You also need to check how the ratio compares with the industry average or with its peers’ operating ratios.
Operating ratio vs. operating expense ratio
Many beginners may assume that the operating ratio is the same as the operating expenses ratio (OER). This is a common mistake because the operating ratio uses the operating expenses of a company. However, the OER is a unique ratio used in the real estate industry. It measures the costs incurred to manage and operate a property against the revenue generated by that property.
The operating ratio, on the other hand, is a common term that applies to companies across various industries and sectors. So, although the two ratios compare similar metrics, the industry-specific usage varies.
Conclusion
To assess a company’s profitability, the operating ratio is an essential metric. That said, it should not be the sole measure you rely on to make investment decisions. You also need to consider other financial metrics like valuation ratios and leverage ratios. If this is too much to assess for each company you are interested in, investing in mutual funds may be a more viable option.
Mutual fund schemes are managed by professional fund managers who perform the necessary analyses for you. If you are looking for suitable mutual funds for your portfolio, check out the 1,000+ schemes available on the Bajaj Finserv Mutual Funds Platform. You can even compare mutual funds on this platform and use the free mutual fund calculator to assess how your investments could potentially grow over any given tenure.
