Definition
Working Ratio is a financial metric that measures an organization’s operational efficiency. It is calculated by dividing the operating expenses (excluding depreciation) by the total cost (including purchases and opening and closing stock). A lower working ratio indicates better performance, as it suggests that the company is managing its operating expenses efficiently.
Key Takeaways
- Working Ratio is a crucial financial metric that measures a company’s operational efficiency by comparing its operating expenses against net sales. It indicates how profitably a company is operating.
- A lower Working Ratio is preferred as it means a larger portion of the company’s revenue is available for growth and expansion, and vice versa. High Working Ratios can indicate inefficiencies in managing operational costs.
- This ratio aids in company performance comparison within the same industry. However, the interpretation of the ratios can vary across different industries. It’s essential to compare companies in similar sectors for a more accurate analysis.
Importance
The finance term working ratio is vitally important as it demonstrates a company’s operational efficiency by gauging the proportion of operating costs to total revenue.
This ratio provides key insights into a firm’s profitability and financial health by showing how much of its revenue needs to be funneled back into sustaining its regular operations.
When the ratio is lower, it positively indicates that a larger portion of a company’s income is available for savings, investments, or expanding business operations.
Thus, keeping an eye on the working ratio allows businesses to ensure they are not overspending to maintain their daily functions and allows stakeholders to better understand the corporation’s efficiency and profitability.
Explanation
The working ratio, a financial metric, serves a crucial purpose in providing an insight into a company’s operational efficiency. It is essentially used to measure the proportion of a company’s operational costs to its total revenue.
In simpler terms, it indicates how much of the generated revenue is being utilised to cover operational expenses. By providing a lens to examine the company’s operational efficiency, it aids investors, management, and other stakeholders in making informed decisions related to the company’s operation and potential investments.
High working ratios usually indicate that a significant portion of the company’s revenue is spent on operating costs and may suggest inefficiencies within operational processes. A lower working ratio, on the other hand, implies better operational efficiency as lesser revenue is spent on covering operational costs.
Thus, the working ratio is a pivotal tool for financial analysis and cost control as it helps identify problem areas within the operational aspects of the business, thereby directing attention to potential areas for cost optimisation.
Examples of Working Ratio
Manufacturing Industry: Let’s consider a manufacturing company manufacturing automotive components. Suppose their annual revenue is $10 million and their cost of operation is $8 million. So, their working ratio would be $8 million / $10 million =8 or 80%. This means that for every dollar earned, they are spending 80 cents to run their operations.
Restaurant Industry: Let’s look at an example from the restaurant industry. If a restaurant’s total income from food sales for a financial year is $500,000 and it spent $300,000 in costs associated with its operations during that same time, then the working ratio would be $300,000 / $500,000 =6 or 60%. This indicates that it costs the restaurant 60 cents to earn every dollar in revenue from food sales.
Retail Industry: Suppose a retail store has an annual income of $1 million and spends $700,000 on operational costs such as paying rent, purchasing merchandise, employment wages, etc. then its working ratio would be $700,000 / $1 million =7 or 70%. For each dollar the store makes, it spends 70 cents to achieve that revenue.
FAQs on Working Ratio
What is the Working Ratio?
The Working Ratio is a financial term used to describe a company’s operating liquidity measured by comparing its working capital to its short-term liabilities. It provides an indication of the company’s short-term financial situation and its ability to meet current obligations.
How is Working Ratio calculated?
The Working Ratio is calculated by dividing current assets (excluding inventory) by current liabilities. Both these figures can be found on a company’s balance sheet. The resulting ratio tells you how many times over a company can pay off its current liabilities using its liquid assets.
What is a good Working Ratio?
Generally, a ratio between 1.2 and 2.0 is considered to be a good Working Ratio. This means the company has enough current assets to cover its short-term debt without relying on the sale of inventory. If the ratio is less than 1.0, it indicates that the company may have trouble meeting its short-term obligations without selling inventory or acquiring more debt.
What does a high Working Ratio indicate?
A high Working Ratio indicates that a company has enough current assets (excluding inventory) to pay off its current liabilities. This is considered a sign of financial stability. However, an excessively high ratio could indicate that the company is not utilizing its current assets effectively to generate revenue.
What does a low Working Ratio tell us?
A low Working Ratio indicates that a company may struggle to pay its short-term liabilities with its current assets (excluding inventory). This could be a red flag for potential liquidity issues, indicating that the company needs to finance its short-term obligations some other way, such as increasing its borrowing or selling assets.
Related Entrepreneurship Terms
- Current Ratio: This is a liquidity ratio that measures a company’s ability to pay short-term obligations.
- Quick Ratio: Also known as the acid-test ratio, it measures a company’s ability to meet its short-term obligations with its most liquid assets.
- Debt Ratio: This is a financial ratio that indicates the percentage of a company’s assets that are provided via debt.
- Operating Expense Ratio (OER): This calculates the cost of operating a piece of property compared to the income that the property brings in.
- Gross Profit Margin: This is a ratio of profitability calculated as gross profit divided by revenue. It measures how efficiently a company uses its materials and labor in the production process.
Sources for More Information
- Investopedia: A comprehensive source for information on finance and investing terms.
- Accounting Tools: Offers detailed explanations and examples about a wide range of accounting and finance terms.
- Finance Formulas: It provides a list of formulas used in finance, along with their explanations.
- WallStreetMojo: Offers insightful articles about various finance and investment concepts.
