The operating ratio is a critical measure of a company’s efficiency. This ratio compares a company’s total operating expense (OPEX) to its net sales, providing valuable insight into how well management is controlling costs while generating revenue. A lower operating ratio indicates a more efficient company in terms of revenue generation versus total expenses.
Key Takeaways
- The operating ratio reveals management efficiency by comparing total operating expenses to net sales.
- A decreasing operating ratio is a positive sign, indicating that operating expenses are becoming a smaller proportion of net sales.
- The ratio does not account for debt, which is a noted limitation.
How the Operating Ratio Works
The formula for the operating ratio is straightforward:
Operating\, Ratio = \frac{Operating\, Expenses\, +\, Cost\, of\, Goods\, Sold}{Net\, Sales}
Here are the steps to calculate it:
- Extract the total cost of goods sold (COGS) from the company’s income statement.
- Find the total operating expenses, typically listed further down the income statement.
- Sum the total operating expenses and COGS and place this value in the numerator of the formula.
- Divide this sum by the total net sales.
- Note that some companies might report COGS within operating expenses, necessitating a closer review.
Insights from the Operating Ratio
Investment analysts use various metrics to analyze company performance, and the operating ratio is one of the favorite tools. It focuses on core business activities and aligns with other efficiency metrics like return on assets (ROA) and return on equity (ROE). Monitoring the operating ratio over time can identify trends of operational efficiency or inefficiency.
A rising operating ratio signals increasing expenses relative to sales, which could suggest inefficiency and potential need for cost control measures. Conversely, a declining ratio suggests improving efficiency through higher revenue, lower expenses, or both.
Components of the Operating Ratio
Operating expenses exclude taxes and interest payments. Companies also typically exclude non-operating expenses from this ratio. Operating expenses cover costs associated with the business operations not directly tied to product or service production. These can include:
- Accounting and legal fees
- Bank charges
- Sales and marketing costs
- Non-capitalized research and development expenses
- Office supply costs
- Rent and utility expenses
- Repair and maintenance costs
- Salary and wage expenses
Although sometimes included within operating expenses, COGS usually requires separate consideration. COGS includes the direct costs tied to production, such as direct materials, labor, rent of production facilities, benefits, wages for production workers, and equipment repair costs.
Net sales (or revenue) appear at the top of the income statement, representing the money generated before deducting expenses. Often, companies will present this value as net sales after returns and allowances.
Example: Apple’s Operating Ratio
Here is an example based on Apple Inc.’s income statement as of June 27, 2020:
- Total revenue or net sales of $59.68 billion
- Total cost of sales (COGS) of $37.00 billion
- Total operating expenses of $9.59 billion
- Operating ratio calculation:
($37.00 billion + $9.59 billion) / $59.68 billion = 0.78 or 78%
This means 78% of Apple’s net sales are allocated to operating expenses. Examining this ratio over several periods can reveal how well Apple manages its operating costs.
Operating Ratio vs. Operating Expense Ratio
The operating expense ratio (OER), often used in real estate, measures property operating costs relative to its income. The OER is calculated by dividing a property’s operating expense, minus depreciation, by its gross operating income. In contrast, the operating ratio applies broadly across industries to assess overall business performance.
Limitations of the Operating Ratio
One limitation is that the operating ratio doesn’t factor in debt. Companies with significant debt will incur large interest payments that are not included in operating expenses. Two companies with identical operating ratios might have vastly different financial health due to different debt levels. Comparing debt ratios is critical before drawing conclusions.
Additionally, it’s essential to monitor the operating ratio across multiple reporting periods to identify trends. Short-term cost cuts can temporarily improve earnings but aren’t sustainable in the long run.
Finally, use the operating ratio in conjunction with other metrics for a comprehensive financial analysis. Comparing the operating ratio with industry peers can also highlight relative efficiencies or inefficiencies.
Related Terms: operating expense, net sales, return on assets, return on equity, non-operating expenses.
