Operating Ratio

What is the Operating Ratio?

The Operating Ratio (OR) establishes the relationship between operating Cost (i.e., Cost of revenue from operations + Operating Expenses, also called OPEX) and Revenue from Operations. It indicates the efficiency of a company’s management. In most cases, the ratio is given as a percentage.

It is one of many business management methods owners or investors may use to determine the company's financial performance.

Components of the Operating Ratio

Direct material expenses, plant rent, direct labor costs, repair charges, etc., are all included in the Cost of goods sold. Operating Cost includes those expenses which are incurred for the operating activities of the business.

Examples are

• Employee benefit expenses
• Accounting and legal fees
• Bank charges
• Sales and marketing costs
• Office supplies
• Repair and maintenance costs
• Non-capitalized R&D expenses

Taxes and interest payments are not considered operating expenses.

Non-operating incomes and expenses are incomes and expenses which are not incurred for the operating activities of the business. These are excluded.

Examples are

• Interest and dividend received
• Interest on loans and debentures
• Gains (profit) or loss on the sale of fixed assets

What Does the Operating Ratio Tell You?

The money that a business earns is typically shown at the top of an income statement as total sales or revenue. As a result of customer returns for products that they credit back to the customer, which is subtracted from revenue, some businesses report revenue as net sales.

If a business' operational ratio is 0.70, or 70%, that means that for every dollar of sales produced, $0.70 is used to cover operating costs.

The excess $0.30 is either used to pay non-operating costs or flows down to net income, which may then be retained or distributed as a dividend to shareholders. This ratio demonstrates how effectively a company's management controls expenditures while producing income or sales. 

The more efficiently a corporation generates income compared to overall expenses, the lower the ratio. It can combine a business's operating expenses and net sales into a single figure that is simpler to compare and analyze over time.

The goal is to assess the reasonableness of the operating expense and asset usage levels. If not, management may take action to reduce some costs or assets.

It is not a comprehensive financial assessment method because debt is not considered. Still, it can be helpful when comparing businesses in the same sectors or tracking development over time.

Operating Ratio Formula

Operating Ratio is a financial metric that measures a company’s operating efficiency. It helps investors and analysts assess a company’s ability to control its expenses and generate profit from its operations.

It is computed as follows:

Operating Ratio = (Cost of Revenue from Operations + Operating Expenses)/ Revenue from Operations * 100

Or

= (Operating Cost/ Revenue from Operations) * 100 = .....%

1. Cost of Revenue from Operations:

= Opening Inventory (Excluding Spare Parts and Loose Tools) + Net Purchases + Direct Expenses - Closing Inventory (Excluding Spare Parts and Loose Tools)

Or

= Revenue from Operations - Gross Profit

Or

= Cost of Materials Consumed + Net Purchases of Stock-in-Trade + Changes in Inventories of Finished Goods, Work-in-Progress and Stock-in-Trade + Direct Expenses

2. Operating Expenses:

= Employees Benefit Expenses + Depreciation and Amortisation Expenses + Other Expenses (Other than Non-operating Expenses)

Or

= Office Expenses + Administrative Expenses + Selling and Distribution Expenses + Employees Benefit Expenses + Depreciation and Amortisation Expenses

Alternatively, Operating Costs can be calculated as follows:

Operating Cost = Cost of Materials Consumed + Purchases of Stock-in-Trade + Changes in Inventories of Finished Goods, Work-in-Progress and Stock-in-Trade + Employees Benefit Expenses + Depreciation and Amortisation Expenses + Other Expenses (other than Non-operating Expenses)

Or

= Cost of Revenue from Operations + Operating Expenses 

The operating profit ratio and OR are complementary; thus, the sum of the two ratios is 100. Another ratio is obtained when one of the two ratios is deducted from 100.

For example, if the operating profit ratio is 25%, the OR is 75%.

Operating Ratio (%) + Operating Profit Ratio (%) = 100

A different way to use the calculation is to leave out manufacturing costs and solely compare administrative costs to net sales. 

This technique produces a significantly lower ratio and helps figure out how much sales must cover fixed administrative costs. This makes it a unique use of the break-even analysis.

Interpreting the Operating Ratio

The objective of computing this ratio is to assess the operational efficiency of the business. It shows the percentage of revenue from operations absorbed by the Cost of revenue from operations (Cost of goods sold) and operating expenses.

Because it focuses on essential business operations, analyzing this ratio is one of the most common approaches to measuring performance. It is frequently used to assess a business's operational effectiveness and return on assets and equity.

A corporation is breaking even on its revenues and operating expenses when its OR is one. A ratio greater than one indicates a loss for the business.

A profit is indicated by an OR that is less than one, and a declining ratio may indicate that the business is getting more efficient.

It is helpful to monitor the ratio on a year-over-year basis to spot patterns in operational efficiency or inefficiency. However, more research is necessary to identify the real reason for the improvement.

A stable ratio shows that a business maintains its efficiency. This could signify that the business's scale and sales have remained stable, or it could mean that its overhead is expanding or contracting at the same rate as its revenue.

A rise in the ratio indicates a decline in efficiency. This may happen when the company's operational costs rise without growth in sales, or it may result from reduced sales but stable operating costs.

In this case, the business must strengthen its system for cost control. It will guarantee that the company's margins will rise over time.

A declining ratio is typically seen favorably because it could mean increased efficiency. If a corporation's sales go up while its overhead costs remain constant or if it streamlines and lowers those costs while retaining the same level of sales, its ratio may go down.

A lower OR is better because it leaves a higher profit margin to meet non-operating expenses, pay dividends, etc.

That is to say, rather than serving as a stand-alone statistic to look to and make inferences from immediately; this ratio is helpful for initial research and identifying trends for further study.

A company with significant operating leverage, or more fixed costs than variable costs, might see great sales growth, but this would result in a drop in the proportion of its overall operating expenses to sales.

The transition does not imply that management is managing the business any better but that the company's cost structure (and profit margins) are positioned to profit from such situations.

Additionally, similar to most ratios, comparisons with other businesses are only worthwhile if they include direct rivals around the same size and stage of development.

Different industries have different norms. As a result, a high ratio for one industry might not apply to another.

Example of the Operating Ratio

Now, let us see some examples that will help us learn the calculation of OR and clarify our concepts.

If the revenue from operations is $ 680,000, the gross profit rate on cost is 25%; Selling expenses are $144,000, and administrative expenses are $73,000; Calculate the operating ratio.

First, let us see the components required for calculating the OR.

Operating Ratio = (Cost of Revenue from Operations + Operating Expenses)/ Revenue from Operations * 100

Now, we will calculate the value of these components, starting with the cost of revenue from operations.

Cost of Revenue from Operations = $68,0000 * ($100/ $125) = $544000 

After this, 

Operating Expenses = Selling Expenses + Administrative Expenses = $144,000 + $73,000 

= $217,000

Therefore, 

OR = ($544,000 + $217,000)/ $680,000 * 100 = ($761,000/ $680,000) * 100 = 111.91%

A ratio of 111.91% indicates a loss for the business.

Let us take another example to make it clearer.

Calculate the OR when operating costs are $680,000, operating expenses are $80,000, and gross profit is 25%.

Let us again see the components required for calculating the OR.

Operating Ratio = (Cost of Revenue from Operations + Operating Expenses)/ Revenue from Operations * 100

Now, we will calculate the value of these components, starting with the cost of revenue from operations.

Cost of Revenue from Operations = Operating Cost - Operating Expenses 

= $680,000 - $80,000 = $600,000

After this,

Revenue from Operations = $600,000 * ($100/ $75) = $800,000

Therefore, 

OR = ($600,000 + $80,000)/ $800,000 * 100 = 85%

This ratio indicates that the business is profitable.

Limitations of the Operating Ratio

The operational ratio's exclusion of debt is one of its drawbacks. Some businesses incur significant debt, which obligates them to pay significant interest payments that are not reflected in the OR's operational expenses calculation. 

Consequently, the analysis may tend to become so skewed. Before drawing any conclusions, it is crucial to evaluate the debt ratios of two organizations because they may have the same operational ratios but varying debt levels.

The ratio should be tracked over several financial years, just like any other financial indicator, to see if a trend emerges. 

Businesses may make short-term cost reductions, which briefly boost their profits. Investors must track costs over time to determine if they are rising or falling and compare the findings to sales and profit performance.

Because this ratio cannot be analyzed in isolation, comparison statistics are necessary to measure, comprehend, and judge the firm's performance using other related data sources.

Finally, it should be used in conjunction with other ratios rather than alone, as is the case with all ratios. One must also consider profitability activity and leverage ratio to assess and comprehend the firm better.

The ratio cannot be compared to companies operating in other industries because that may not be an appropriate benchmark. One must investigate comparable businesses to facilitate comparison and better comprehend the firm when seen relatively.

Researched and authored by Harveen Kaur Ahluwalia | LinkedIn

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