Definition
Operating Ratio is a financial metric that is used to assess a company’s operational efficiency. It is calculated by dividing operating expenses by net sales and then multiplying the result by 100 to express it as a percentage. A lower ratio is generally seen as favorable, indicating a company is generating more revenue relative to its operational costs.
Key Takeaways
- The Operating Ratio is a key financial measurement that assists businesses in assessing their operational efficiency by comparing operating expenses to net sales. It provides key insight into a company’s ability to turn sales into profits.
- A lower Operating Ratio generally signifies a greater operational efficiency and profitability, as it indicates that a company is spending less to generate each dollar of sales. High ratios, on the other hand, might suggest inefficiency or potential profitability issues.
- The Operating Ratio can fluctuate from industry to industry or from one company to another, and while it is a useful tool for comparing similar companies within a single industry, it’s less useful when comparing companies in different sectors.
Importance
The Operating Ratio is a vital financial term as it assists in the assessment of a company’s operational efficiency by comparing its operating expenses to its net sales.
The metric helps businesses to review cost management, evaluate performance over time, or compare operations within their industry.
A lower ratio typically indicates higher profitability and operational efficiency, as it suggests the company is generating sufficient revenue to cover its operational costs.
Therefore, the operating ratio is an important tool for businesses and investors in analyzing the financial health of a company.
Explanation
The primary purpose of the Operating Ratio is to evaluate the operational efficiency and performance of a company. It provides an in-depth overview of how much a company spends on its operating expenses, such as cost of goods sold, labor costs, and administrative expenses, in relation to its net sales.
The lower the operating ratio, the more profitable the company’s core business activities are considered, and vice versa. It gives the stakeholders, investors, and company management a clear idea about the company’s operational cost structure and its capability to generate profit from regular business operations.
The Operating Ratio is utilized as a critical financial metric in industries where high-volume transactions occur, and operating costs play a substantial role in determining profitability, such as the manufacturing and logistics sectors. In a competitive environment, it serves as a benchmark for companies to compare their operating efficiencies with rivals in the same industry.
It also aids in decision-making as it helps highlight areas where operating costs might be reduced to improve profitability. In a broader context, the operating ratio helps to analyze trends over time and indicates whether the company is improving its efficiency or falling behind.
Examples of Operating Ratio
Amazon Inc.: Amazon has a very efficient operating ratio, which is one of the leading reasons why the company is so profitable. For instance, in 2020, Amazon’s operating ratio was approximately 95%, signifying that it spent 95% of its net sales on operating expenses. This ratio reveals the company’s operational efficiency and its ability to generate profits from sales.
Walmart Inc.: Walmart, another retail giant, operates on thin margins but continues to be profitable due to its huge sales volume. In 2020, its operating ratio averaged around 80%. This means that roughly 80% of Walmart’s revenue went towards meeting its operational costs like cost of goods sold and administrative expenses. The remaining 20% was divisible between other commitments such as interest payments, taxes, and net profit for shareholders.
United Parcel Service (UPS): This logistics company’s operating ratio represents the costs and expenses incurred from its daily business operations. In 2020, UPS achieved an operating ratio of
4%, which means only about
6% of the company’s income is actual profit. This ratio demonstrates that UPS spends a large portion of its revenue on operating costs, including fuel, labor, and maintenance of vehicles.
Operating Ratio FAQ
What is Operating Ratio?
Operating Ratio is a financial term used to measure a company’s operational efficiency. It’s calculated as the ratio of operating expenses to net sales. It is often expressed as a percentage, with lower values indicating more effective company management.
How is Operating Ratio Calculated?
The Operating Ratio is calculated by dividing operating expenses (such as wages, rent, and material costs) by net sales. The formula is: Operating Ratio = (Operating Expenses / Net Sales) * 100. The final result provides the percentage of sales consumed by operating expenses.
What Does a High Operating Ratio Indicate?
A high Operating Ratio indicates that a larger portion of a company’s revenue is being consumed by operating expenses. This could suggest inefficiencies in management or operations, and can potentially be a warning sign for investors or other stakeholders.
How Can a Company Improve Its Operating Ratio?
Improving an Operating Ratio requires either increasing net sales, decreasing operating expenses, or both. Strategies might include negotiation with suppliers for lower cost of goods sold, better inventory management, improvement in product pricing, or cost cuts in areas such as labor, marketing or research, and development.
Is Operating Ratio the Same as Operating Margin?
No. Operating Ratio and Operating Margin are related, but different metrics. While Operating Ratio measures the percentage of a company’s sales that goes towards operational costs, Operating Margin measures what proportion of revenue is left after paying those costs. Thus, Operating Margin is calculated as 1 – Operating Ratio.
Related Entrepreneurship Terms
- Operating Expense
- Net Sales
- Gross Profit Margin
- Cost of Goods Sold (COGS)
- Operating Profit
Sources for More Information
- Investopedia: Detailed financial education content with explanations of multiple terms and metrics, including the operating ratio.
- Corporate Finance Institute: Offers professional training and knowledge in finance, including lessons on various financial ratios.
- Finance Formulas: A website providing comprehensive formulas in finance and explanations.
- Accounting Tools: Provides a variety of resources for understanding accounting and finance concepts.
