Financial experts often calculate various ratios from company records to understand a company's financial stability and reflect its progress. The operating ratio helps ascertain the company's net sales and operating costs into a single number that's easier to compare and track over time. Calculating an operating ratio can be helpful if you're researching a company's financial history for investment considerations. This article discusses what an operating ratio is, how to calculate it, and how to interpret operating ratio trends. The operating ratio is vital to know the company's management's efficiency. In this blog, we will pen down the operating ratio and how to calculate the Operating Ratio.
What is an Operating Ratio?
The operating ratio is the ratio computed by dividing the operational expenses of a particular period by net sales made during that period. It is also termed as Operating cost ratio or operating expense ratio). The operating ratio can be calculated by considering production and administrative expenses to net sales. It reveals the cost per sales rupees of running a business. A low ratio compared to competitors indicates that management is excellently keeping costs in line. The ratio indicates the efficiency of a company's management by comparing the total operating expense of a company to net sales.
The operating ratio is computed as follows:
The essential components of the formula are operating costs and net sales. Operating cost is equal to the cost of goods sold plus operating expenses. Non-operating expenses such as interest charges, taxes, etc., are excluded from the calculations.
Operating Ratio=Operating Expenses/Net Sales � 100
The Below mentioned example may help understand the computation of the operating ratio.
The particulars of XYZ Company limited are given below:
- Net sales: 400,000
- Cost of goods sold: 160,000
- Administrative expenses: 35,000
- Selling expense: 25,000
- Interest charges: 10,000
From the above-mentioned details, we will Compute the operating ratio for XYZ Company Limited
= (220,000* / 400,000) � 100 = 55%
The operating profit ratio is 55%. It indicates that 55% of the sales revenue would be used to cover the cost of goods sold and other operating expenses of XYZ Company Limited.
How to Calculate the Operating Ratio
To calculate the operating ratio, sum up all production costs and administrative expenses and divide by net sales. Net sales mean Gross sales minus sales discounts, returns, and allowances). The measure excludes financing costs, non-operating expenses, and taxes.
The Operating Sales ratio is calculated in a below-mentioned manner:
Operating Ratio=(Production expenses + Administrative expenses) � Net sales.
Another formula for Operating Ratio excludes production expenses so that administrative only expenditures are compared against net sales. This formula yields a much lower ratio and helps ascertain the amount of fixed administrative costs that sales must cover. As such, it is a variation in the breakeven calculation. Here the operating ratio is calculated by considering this formula-
Operating Ratio=Administrative expense � Net sales
Interpretation and Importance of Operating Ratio
The operating ratio is used to measure the operational efficiency of the management. It shows whether or not the cost component in the sales figure is within the normal range. A low operating ratio means a high net profit ratio and vice versa.
The Operating ratio should be compared-To the company's past years' ratio.
- With the proportion of other companies in the same industry.
Analysis of Operating Ratio
Any person can analyze the operating ratio value by getting limited information on a company's finances. Here's what a single operating ratio can tell you:
- The operating ratio is equal to one: An operating ratio of 1 reflects that a company is on break even on its sales and operating costs.
- Operating ratio of more than one: An operating ratio of more than one reflects the company is losing money.
- Operating ratio below one: An operating ratio less than one depicts a profit, and a low operating ratio can show the company is becoming more efficient.
Use of Operating Ratio
Financial experts or investors may use the operating ratio to examine businesses in various ways. Below mentioned are a few of the examples where operating ratios can be used:
- While doing research for Investment - Operating ratios can help decide whether to invest in a publicly-traded company, as it helps in exhibiting performance over time.
- Industry comparison - Mainly this ratio helps compare Peer competitors in the same industry. The reason is the operating costs per sale are likely to be similar.
- Examining different financial strategies - Researching the differences in operating ratios between companies can help potential investors understand the financial strategies behind them.
Benefits of Operating Ratio
Financial parameters to Assess Business: It is an essential facilitator of ratio analysis by comparing the business's expenses to that of the revenues and thus serves as a necessary financial assessment tool in understanding the company's health.
Provides Time Series Analysis: By serving as a metric to gauge the operational ability of a company, this ratio also tends to facilitate time series analysis over periods of the same company. This way, one can overview if a company fared better in this particular metric in the previous years or did well in the current year. This way, a time series analysis of a company can be undertaken over a time frame.
Provides Cross-Sectional Comparison: Operational Ratio helps in intercompany comparison by helping to overview the same ratio of different companies. The ratio can also be compared against the industry parameter to gauge and understand if the performance is in line with the industry and competitors and if there is scope for growth and performance improvement.
Serves as an Indicator to Show Efficiency of Management: By comparing the company's operating expenses with that of the turnover, one can understand if the company is efficient in managing its expenses. A lower ratio is a good sign, whereas an increasing ratio tends to act as a red signal as it indicates the expenses are increasing over time, and it is imperative to keep a tab on the same.
Types of Operating Ratio
The term "inventory turnover" refers to the period between the date the item is purchased by a business until it is eventually sold. A full inventory turnover signifies that the business had sold the stock it bought, and fewer items were damaged or lost due to shrinkage.
The inventory turnover ratio is the number of times a company has sold and replenished its inventory over time. The formula can also calculate the number of days it will take to sell the inventory on hand. The turnover ratio is derived from a mathematical calculation, where the cost of goods sold is divided by the average inventory for the same period. A higher ratio is more desirable than a low one as a high ratio tends to point to strong sales.
Knowing your turnover ratio depends on effective inventory control where the company has good insight into what it has on hand.
2.Days of Inventory on Hand
Managing inventory is the backbone of the supply business. It is essential to know how long one's inventory will last and plan accordingly. Inventory days on hand are a make-or-break part of the business cycle. Hence, it is essential to know how it works.
Keeping track of inventory days on hand will help with forecasting, tracking, and calculating how soon a lot of inventory will last or get exhausted. Inventory days on hand measure how much time is needed for a business to exhaust a lot of inventory on average. By knowing the current and exact value of inventory days on hand, a business can reduce its stockout days. The lower the number of inventory days on hand, the better it is for the company.
Calculating the inventory days on hand requires a simple formula involving the average inventory for the year for your business and the cost of goods sold. To calculate, we multiply the average inventory for the year by 365 and then divide it by the value of the cost of goods sold.
Inventory Days on Hand = (Average Inventory for the Year / Cost of Goods Sold) X 365
The accounts receivable turnover ratio, also known as the debtor's turnover ratio, is an efficiency ratio that measures how efficiently a company is collecting revenue and by extension, how efficiently it is using its assets. The accounts receivable turnover ratio measures the number of times over a given period that a company collects its average accounts receivable.
The accounts receivable turnover ratio formula is as follows:
Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
Net credit sales are sales where the cash is collected at a later date. The formula for-
Net credit sales = Sales on credit � Sales returns � Sales allowances.
Average accounts receivable is the sum of starting and ending accounts receivable over a time period (such as monthly or quarterly), divided by 2.
4. Payable Turnover
This ratio measures how quickly a business makes payments to creditors and suppliers that extend lines of credit. Accounting professionals quantify the ratio by calculating the average number of times the company pays its AP balances during a specified period. On a company's balance sheet, the accounts payable turnover ratio is a key indicator of its liquidity and how it is managing cash flow.
payable turnover rates are typically calculated by measuring the average number of days that an amount due to a creditor remains unpaid. Dividing that average number by 365 yields the accounts payable turnover ratio.
Accounts Payable Turnover Ratio = the Average number of days / 365
5.Operating Assets Ratio
The operating assets ratio compares the assets used to generate revenues to total non-cash assets. The intent is to eliminate those assets not contributing to operational performance, which reduces the total asset base of a business. By doing so, management can reduce the amount of cash invested in a business, so that it operates in a more efficient manner.
Operating Assets Ratio = Operating Assets / Total Assets
- Operating assets are those used to create revenue.
- Operating assets and total assets are gross values, meaning they are not net of depreciation.
6.Operating Expenses to Sales Ratio
The operating expenses to sales ratio compares the number of operating expenses incurred to a given sales level. The result is usually tracked on a trend line, to see if the proportion is changing over time. The analysis does not always work, since many operating expenses are fixed, and so do not vary directly with sales. Also, if the analysis is used to pare back operating expenses too much, customer service levels may suffer.
7.Net Profit Ratio
The net profit ratio compares after-tax profits to sales. This is an indirect measure of operating expenses since the percentage also includes the cost of goods sold, financing costs, and income taxes. Nonetheless, it gives the best overall view of the financial performance of a business.
8.Sales per Employee
compares full-time equivalent headcount to sales. This is used in environments where employees are deeply involved in sales, so there is a direct relationship between headcount and sales; it is more commonly applied to a services business, such as consulting. The ratio is included here because the cost of compensation can comprise a large part of total operating expenses.
Functioning of Operating Ratio
In general, the functioning of the Operating ratio can be very well estimated by bifurcating between fixed and variable expenses based on the nature. If the expenses are variable, the % ratio of these expenses will not change much due to an increase or decrease in revenues. In this scenario, it's a sign indicating further investigation. Similarly, if the expenses in a particular operating expense comprise mainly fixed expenses, which should remain fixed regardless of the change in revenues, the % operating ratios should decrease with an increase in revenues.
In a nutshell, the operating ratio is an effective way to evaluate the company's core operations. The reason is that it is based on operating income and is not influenced by changes in companies' capital structures or financing decisions. This ratio is also an indirect measure of efficiency. The less the ratio, the more efficiently the company is creating profits.
It is essential to consider that some industries have higher or lower operating expense requisites than others. Thus, comparing operating ratios is generally meaningful among companies dealing in the same industry, and the analysis of High or Low operating ratios should be made within this context.