What is Operating Ratio?
Operating ratio is a financial parameter which shows the relationship between the operating profit and net sales of the company. The operating ratio shows how efficiently the company is running its operations and generating revenue or sales. The smaller the ratio, the more efficient is the operation of the company and more revenue the company is generating w.r.t. its total expenses.
Operating ratio includes operating expenses and cost of goods sold. Let us understand these terms before moving further.
Operating expenses are the expanses which are incurred in running a business but are not directly associated with the production or the product. These are overhead expenses which includes the following:
- Salary and wages
- Cost of sales and marketing
- Research and development charges
- Office supply costs
- Accounting and legal fee
Cost of Goods Sold
Operating expenses may also include cost of goods sold which are the costs directly associated to the production of goods or services. These expenses include the following:
- Material & labor costs
- Rent of production facility
- Repair of machinery and equipment
Some companies add the cost of goods sold to the operating expenses, to make it a part of operating expenses however some companies keep it separate. Therefore, it is always a good practice to check whether the cost of goods sold is a part of operating expenses. If it is not a part of operating expenses, then it is to be added in operating expenses for the calculation of operating ratio.
How the Operating Ratio is Calculated?
Cost of goods sold, which is called cost of sales is extracted from the company’s income statement.
Total operating expenses are also determined from the income statement of the company.
Add the operating expenses to the cost of goods sold and divide the sum from the net sales of the company.
Note that some companies include the cost of goods sold in the operating expenses. Therefore, this should be checked while calculating the operating ratio.
Significance of Operating Ratio
Operating ratio tells us about the efficiency of operations of the organization. If you keep track of the operating ratio of a company over a period of time, you can have an idea whether the company is efficient or inefficient in its operations.
A higher operating ratio is not a good sign w.r.t. the operating efficiency of the company since it means that the operating expanses of the company are more as compared to its net sales or revenue and it is not profitable. On the other hand, if the operating ratio of a company is less, it means that the company is generating more revenue from its operations and it is efficiently running its operations. If the operating ratio of the company is high, then the company needs to implement cost control measures to lower its cost of operations.
The investors need to monitor the operating ratios of the company over a period of time to check whether the company is becoming efficient or inefficient over a period of time. It is also important to compare the operating ratio of the company with the standard operating ratio of the industry or with the rival companies to analyze the performance of a company.
Limitations of Operating Ratio
The limitation of the operating ratio is that it does not incorporate debt in its calculation. Some companies take a large amount of debt and pay large sum on account of interest, which is not reflected in operating expenses. It means that a company paying large amount of interest may have low operating ratio and company seems to be efficient in operations although it is actually inefficient. Two company may have the same operating ratios, while having the different debt levels, therefore it is important to compare the debt ratios of the companies before arriving on any conclusion.
Calculate the operating ratio of ABC. Pvt. Ltd from the following data:
Net sales of the company= ₹3,50,000
Cost of goods sold= ₹1,50,000
Administrative expenses= ₹55,000
Selling expenses= ₹15,000
Internet charges= ₹12,000
Operating ratio= 150000+55000+15000= 220000
Net sales of the company= ₹350000
= 0.63 or 63%
The operating ratio is a crucial parameter of the ratio analysis, which determines the operating efficiency of a business. The operating ratio shows how efficiently the company is running its operations and generating revenue or sales. The smaller the ratio, the more efficient is the operation of the company and more revenue the company is generating w.r.t. its total expenses. The investors need to monitor the operating ratios of the company over a period of time to check whether the company is becoming efficient or inefficient over a period of time. It is also important to compare the operating ratio of the company with the standard operating ratio of the industry or with the rival companies to analyze the performance of a company.