In financial analysis, numbers tell a story. Business growth and risks can be identified and operational efficiency or inefficiency can be determined. One often overlooked metric is the operating ratio.
Whether you are tracking operational efficiency as a business owner, reviewing a company's fundamentals as an investor, or learning about financial ratios as a student, understanding the operating ratio meaning, operating ratio formula and real-world meaning of the ratio can enhance your decision-making.
This guide will explain operating ratios in plain English and provide a solid understanding for operating ratio analysis, along with examples, interpretation, limitations, and the importance of this financial metric.
What is Operating Ratio?
Operating Ratio Definition- To understand what an operating ratio is, it can be defined as a metric that assesses business efficiency. It relates to how much operating revenue is consumed by a company's expenses.
The operating ratio answers the following question:
How well is a company managing its primary business activities?
The operating ratio assesses operating expensesversus net sales (revenue). If a company has a lower operating ratio, that company is most likely spending less money to make revenue and is, therefore, operationally more efficient.
Operating Ratio Formula Explained
To calculate the operating ratio, simply use the equation:
What counts as operating expenses?
Operating expenses include:
- Cost of Goods Sold (COGS)
- Administrative Expenses
- Selling and Distribution Expenses
- Rent, Utilities, and Salaries
- Repairs and Maintenance
Operating expenses do notinclude:
- Interest expenses
- Taxes
- Extraordinary or one-time items
This ensures that the ratio is reflective of pure business operations, free of financing or tax fluctuations.
What Makes Operating Ratio Valuable?
With the operating ratio, we can answer the following questions: Is the company improving in efficiency as it scales?
Many businesses set out to grow revenue, but if expenses increase faster than revenue, the company becomes unprofitable. Having a good operating ratio paints a clearer picture for stakeholders before it becomes a challenge.
There are multiple reasons why investing in the analysis of the operating ratio is a good idea. Operating ratio analysis is useful in the following ways:
- It assists in benchmarking businesses in the same market.
- It indicates how well costs are managed over a period.
- It brings to the surface operational challenges that are hidden when revenue increases.
- It complements margin analysis and the longer-term viability of profit.
Understanding Operating Ratio
Operating Ratio is great to understand in theory but a cost-benefit analysis is equally as valuable as the operating ratio, also.
What Does a Low Operating Ratio Mean?
In a broad sense, a low operating ratio indicates:
- Effective cost management.
- Streamlined processes.
- Improved pricing strategy.
- Increased prospective operating profit margins.
Example:
An operating ratio of 65% means Company A spends ₹65 to generate ₹100 in revenue.
High Operating Ratio
A high operating ratio indicates:
- Increasing cost of operations
- Ineffective procedures
- Poor cost controls
- Possible erosion of profits
Example:
An operating ratio of 85% means there is only ₹15 left over before interest and taxes.
Operating Ratio Example (How It Works)
Now, let us consider the operating ratio in this particular example.
Assume the following for a specific firm:
Net Sales: ₹1,000 crore
Operating Expenses: ₹720 crore
This implies that the company consumes 72% of its revenue in operational costs, and has 28% remaining for taxes, interest, and profit.
Operating Ratio vs Operating Margin
Operating Ratio is often confused with Operating Margin, but even though they are closely linked, they tell opposite stories.
- Operating Ratio is about costs.
- Operating Margin is about profits.
Mathematically:
If a company has a 70% operating ratio, that means its operating margin is 30% and vice versa. In combination, both of these ratios provide a complete overview of the operational efficiency of a business.
Industry-Specific Analysis of Operating Ratios
Understanding how operating ratios function is crucial for accurately benchmarking businesses within a given industry. Such context not only helps to avoid misguided assumptions when comparing operating ratios by industry but is also important for industry analysis.
Capital-Intensive Industries
Industries that have higher operating ratios due to large fixed costs include manufacturing, logistics, airlines, and infrastructure.
Asset-Light Industries
Industries such as IT services, consulting, and software have lower operating ratios due to higher flexibility and lower operating costs.
For this reason, this operating ratio analysis should be focused and customised by industry.
Operating Ratio Trend Analysis
The analysis of a single year’s operating ratio will provide you with insufficient information. As such, the most important contributions to business operational analysis arise from trend analysis.
If a company’s operating ratio is:
Decreasing year after year → Improvements in efficiency
Increasing consistently → Rising cost pressures
This is an instrumental analysis for long-term investors to gauge management’s efficiency and operational control of the business.
Analysing Operating Ratios From an Investor’s Perspective
For investors, the operating ratio is a risk detection tool. An increasing operating ratio indicates:
- Increasing cost of raw materials
- Increasing wages
- Cost pressures
- Increased poor cost control
- Less competitive advantage
The operating ratio often detects problems early, even before profit begins to decline. On the other hand, a declining or stable operating ratio indicates great operational execution.
Operating Ratio in Basics of Analysis
Along with other financials, the operating ratio in basic analysis is used with:
- Operating margin
- Net profit margin
- Return on equity (ROE)
- Return on capital employed (ROCE)
These metrics identify if profit is a result of efficiency or financial engineering.
Operating Ratio Drawbacks
While the operating ratio is valuable, it has its drawbacks:
- Neglect of capital structure.
- Disregard for financing and tax efficiencies.
- Volatility due to various accounting policies.
- Lesser value for inter-industry analysis.
- Therefore, operating ratio analysis should be used in conjunction with other metrics.
Methods Businesses Use for Improving Operating Ratio
Businesses try to enhance operating ratios through various ways like:
- Improved sourcing.
- Increased automation and technology use.
- Streamlined supply chains.
- More efficient processes.
- Improved pricing strategies.
A trend often seen in improved operating ratios is the expansion of margins and acceleration of earnings growth.
Operating Ratio Explained Using Real World Examples
Most market leaders prefer to concentrate on operational ratio discipline rather than headline growth. Companies that consistently control costs tend to survive downturns better and create long-term shareholder value. This is why operating ratio is considered the most sincere efficiency ratio by most analysts.
Final Thoughts: Why Operating Ratio is Important
Operating ratio is more than just any other financial metric. It gives you insight into the operational heart of the company. Knowing the operating ratio meaning, the operating ratio formula, and performing operating ratio analysis helps you to identify the company as efficient and cost-light, and helps you in making better financial management.
This is why operating ratio explained correctly is a skill one must acquire to analyse businesses beyond superficial profits.
DISCLAIMER: This blog is NOT any buy or sell recommendation. No investment or trading advice is given. The content is purely for educational and information purposes only. Always consult your eligible financial advisor for investment-related decisions.
