Operating Ratio: Definition and Formula for Calculation (2024)

What Is an Operating Ratio?

The term operating ratio refers to the efficiency of a company's management by comparing the total operating expense (OPEX) of a company to net sales. The operating ratio shows how efficient a company's management is at keeping costs low while generating revenue or sales. The smaller the ratio, the more efficient the company is at generating revenue vs. total expenses.

Formula and Calculation of Operating Ratio

The formula used to calculate the operating ratio is:

$Operating\, Ratio = \frac{Operating\, Expenses\, +\, Cost\, of\, Goods\, Sold}{Net\, Sales}$OperatingRatio=NetSalesOperatingExpenses+CostofGoodsSold​

1. From a company's income statement take the total cost of goods sold (COGS), which can also be called the cost of sales.
2. Find total operating expenses, which should be farther down the income statement.
3. Add total operating expenses and the COGS and plug the result into the numerator of the formula.
4. Divide the sum of operating expenses and COGS by the total net sales.
5. Please note that some companies include the COGS as part of operating expenses while other companies list the two costs separately.

Understanding the Operating Ratio

Investment analysts have many ways of analyzing company performance. Because it concentrates on core business activities, one of the most popular ways to analyze performance is by evaluating the operating ratio.

See Also
Understanding Your Cash Flow Coverage RatioUnderstanding the Cash Coverage Ratio and How to Calculate It

A company's operating ratio is commonly used along with its return on assets (ROA) and return on equity (ROE) to measure a company's operational efficiency. It is useful to track the operating ratio over time to identify trends in operational efficiency or inefficiency.

An operating ratio that is going up is viewed as a negative sign. That's because this indicates that operating expenses are increasing relative to sales or revenue. But, if the operating ratio is falling, it means that the company's expenses are decreasing or revenue is increasing. In some cases, it may be some combination of both.

A company may need to implement cost controls for margin improvement if its operating ratio increases over time.

Components of the Operating Ratio

Remember that a company's operating ratio compares its operating expenses to its net sales. While the term net sales refers to a company's gross sales less its returns, allowances, and discounts, its operating expenses are essentially all expenses except taxes and interest payments. Also, companies will typically not include non-operating expenses in the operating ratio.

Operating expenses are the costs associated with running a business and are not directly tied to the production of a product or service. Operating expenses include overhead expenses like sales, general, and administrative costs. An example of overhead might be the expense of the corporate office for a company because although necessary, it's not directly tied to production. Operating expenses can include:

• Accounting and legal fees
• Bank charges
• Sales and marketing costs
• Non-capitalized
• Office supply costs
• Rent and utility expenses
• Repair and maintenance costs
• Salary andwage expenses

Operating expenses can also include COGS, which are the expenses directly tied to the production of goods and services. However, most companies separate operating expenses from this figure. Therefore, the two costs must be added together to form the numerator in the operating ratio calculation. A company's cost of goods sold can include the following:

• Direct material costs
• Direct labor
• Rent of the plant or production facility
• Benefits and wages for the production workers
• Repair costs of equipment

Revenue or net sales is the top line of the income statement and is the amount of money a company generates before expenses are taken out. Some companies list revenue as net sales because they have returns of merchandise from customers whereby they credit the client back, which is deducted from revenue.

All of these line items are listed on the income statement. Companies must clearly state which expenses are operational and which are designated for other uses.

Limitations of the Operating Ratio

A limitation of the operating ratio is that it doesn't include debt. Some companies take on a great deal of debt, meaning they are committed to paying large interest payments, which are not included in the operating expenses figure of the operating ratio. Two companies can have the same operating ratio with vastly different debt levels, so it is important to compare debt ratios before coming to any conclusions.

As with any financial metric, the operating ratio should be monitored over multiple reporting or accounting periods to determine if a trend is present. Companies can sometimes cut costs in the short term, thus inflating their earnings temporarily. Investors must monitor costs to see if they're increasing or decreasing over time while also comparing those results to the performance of revenue and profit.

It's also important to compare the operating ratio with other firms in the same industry. If a company has a higher operating ratio than its peer average, it may indicate inefficiency and vice versa. Finally, as with all ratios, it should be used as part of a full ratio analysis, rather than in isolation.

Operating Ratio vs. Operating Expense Ratio

Don't confuse the terms operating ratio with operating expense ratio. The operating ratio is the comparison of a company's total expenses compared to the revenue or net sales generated. It is used for company analysis in various industries.

The term operating expense ratio (OER), on the other hand, is used in the real estate industry. It is used to measure what it costs to operate a property compared to the income that the property generates.

The operating expense ratio is calculated by dividing a property's operating expense (minus depreciation) by its gross operating income. The OER is used for comparing the expenses of similar properties.

Example of Operating Ratio

Below is the income statement for Apple(AAPL), according to the company's second-quarter results for the 2024 fiscal year:

• Apple reported total revenue or net sales of $90.75 billion for the period.
• The total cost of sales (or cost of goods sold) was $48.48 billion while total operating expenses were $14.37 billion.

We calculate the numerator of the operating ratio by adding $48.48 billion (COS) + $14.37 billion (operating expenses) for a total of $62.85 billion for the period. The operating ratio is calculated as follows: $62.85 billion ÷ $90.75 billion, which equals 0.69 or 69%. The operating ratio for Apple means that 69% of the company's net sales are operating expenses.

Its operating ratio must be examined over several quarters to get a sense of whether the company is managing its operating costs effectively. Investors can also monitor operating expenses and cost of goods sold separately to determine whether costs are either increasing or decreasing over time.

The Bottom Line

Metrics allow corporate management teams, analysts, and investors to understand a company's financial position. Many of these metrics are expressed as ratios, such as the operating ratio. This ratio compares a company's operating expenses (the costs incurred during normal operations) to its net sales. You can determine how efficient a company is when it comes to managing its expenses—a high ratio or one that increases means that its expenses are getting out of hand while a low ratio means that the company is able to keep its costs down while it generates revenue.