Operating ratio: Meaning, Criticisms & Real-World Uses

Operating Ratio

The operating ratio is a key financial metric used in financial statement analysis that measures a company's efficiency by comparing its operating expenses to its revenue. This metric falls under the broader category of efficiency ratios, which are designed to assess how effectively a company utilizes its assets and manages its liabilities. A lower operating ratio generally indicates greater operational efficiency and a stronger ability for the organization to generate profitability.

History and Origin

The practice of using financial ratios to analyze a company's financial performance has roots dating back to the late 19th and early 20th centuries. As businesses grew in complexity and capital markets developed, the need for standardized tools to assess a firm's health became apparent. Early forms of ratio analysis were often employed by creditors and managers to evaluate aspects like solvency and efficiency. Over time, as accounting practices evolved and more detailed income statement and balance sheet data became available, specialized ratios like the operating ratio emerged. The evolution of financial ratios, from historical perspectives to their current multifaceted uses, highlights their enduring role as analytical tools across various industries⁵. The operating ratio became particularly prominent in capital-intensive industries, such as railroads, where the relationship between operational costs and earned revenue is critical for understanding performance.

Key Takeaways

The operating ratio indicates a company's operational efficiency by comparing operating expenses to revenue.
A lower operating ratio signifies better cost management and higher profitability.
It is particularly relevant in industries with high fixed or variable operating costs, such as transportation.
The ratio helps investors and analysts assess how effectively management controls everyday business expenses.
An operating ratio above 100% means a company's operating expenses exceed its revenue, indicating an operating loss.

Formula and Calculation

The formula for the operating ratio is straightforward:

\text{Operating Ratio} = \frac{\text{Operating Expenses}}{\text{Net Sales}}

Where:

Operating Expenses include the costs associated with a company's primary operations, such as selling, general, and administrative (SG&A) expenses, cost of goods sold (COGS), and depreciation. These are typically recurring costs necessary to run the business.
Net Sales refer to the total revenue generated from sales after deducting returns, allowances, and discounts.

The resulting ratio is usually expressed as a percentage. For instance, an operating ratio of 0.80 would be expressed as 80%.

Interpreting the Operating Ratio

Interpreting the operating ratio involves assessing how much of each dollar of net sales is consumed by operating costs. A lower operating ratio is generally favorable, as it suggests that a company is efficient in managing its expenses relative to its revenue. For example, an operating ratio of 75% implies that 75 cents of every dollar of sales are used to cover operating expenses, leaving 25 cents for non-operating expenses, taxes, and profit. Conversely, a higher operating ratio indicates that a larger portion of revenue is being used for operations, potentially leaving less for profit or reinvestment.

Context is crucial when interpreting the operating ratio. Companies in different industries will have varying typical operating ratios due to their unique cost structures. For instance, a service-based business might have a lower operating ratio than a manufacturing company with significant production costs. Trends over time for a single company are also important; a consistently decreasing operating ratio suggests improving operational efficiency, while an increasing one may signal rising costs or declining sales. Analysts often compare a company's operating ratio against its historical performance, industry averages, and competitors to gain meaningful insights into its profitability and cost control.

Hypothetical Example

Imagine "Freight Movers Inc.," a trucking company, reports the following figures for its latest fiscal year:

Total Revenue: $5,000,000
Operating Expenses (including fuel, maintenance, salaries, etc.): $4,250,000

To calculate the operating ratio:

\text{Operating Ratio} = \frac{\text{\$4,250,000}}{\text{\$5,000,000}} = 0.85

Expressed as a percentage, Freight Movers Inc.'s operating ratio is 85%. This means that for every dollar of revenue generated, 85 cents are spent on operating expenses. Investors would then compare this 85% with industry benchmarks, historical data for Freight Movers Inc., and the ratios of its competitors to evaluate its operational efficiency and financial performance.

Practical Applications

The operating ratio is a vital tool for various stakeholders in assessing a company's health and efficiency.

Investors and Analysts: They use the operating ratio to gauge how well a company manages its day-to-day operations and controls costs. A consistent or improving operating ratio can signal strong management and a sustainable business model. It's often used in conjunction with other metrics to perform comprehensive financial analysis.
Management: Company management utilizes the operating ratio as an internal key performance indicator (KPI) to monitor cost efficiency. By tracking this ratio, managers can identify areas where operating expenses are increasing disproportionately to revenue and implement strategies to improve cost control or boost sales.
Industry-Specific Analysis: The operating ratio is particularly critical in industries with substantial operating costs, such as transportation (e.g., airlines, railroads, trucking) and utilities. In railroading, for instance, an operating ratio below 80% is often considered desirable, and companies in the sector strive for ratios in the mid-50s to 60s to ensure sufficient capital for investments and shareholder returns⁴. The Securities and Exchange Commission (SEC) also has specific disclosure requirements for public companies regarding financial data, including aspects that contribute to operating expenses, ensuring transparency for investors³.

Limitations and Criticisms

While a valuable indicator, the operating ratio has several limitations:

Industry Specificity: What constitutes a "good" operating ratio varies significantly across industries. A ratio that is excellent for a railroad company might be poor for a software firm. Direct comparisons across dissimilar industries are generally unhelpful.
Exclusion of Non-Operating Items: The operating ratio focuses solely on operational costs, excluding non-operating expenses like interest payments and taxes. This means it doesn't provide a complete picture of a company's overall profitability or its ability to manage debt management or other financial obligations. For instance, a company might have an excellent operating ratio but struggle with high interest expenses.
Potential for Manipulation: Management might temporarily reduce operating expenses in ways that negatively impact long-term growth or quality to improve the operating ratio, such as cutting essential maintenance or research and development.
External Factors: The operating ratio can be significantly impacted by external factors beyond management's control, such as fluctuating fuel prices or economic downturns that affect revenue or input costs. For example, a study on railway operating efficiency highlighted that factors like changes in fuel prices can significantly influence the operating ratio, independent of management's direct operational decisions².
Capital-Intensive Bias: It tends to be more relevant for capital-intensive businesses where operating costs form a large proportion of total expenses. For businesses with high capital expenditures and lower recurring operating costs, other financial ratios might offer more insights.

Operating Ratio vs. Operating Margin

The operating ratio and operating margin are two closely related metrics that both assess a company's operational efficiency, but they are inversely related.

The operating ratio expresses operating expenses as a percentage of revenue. A lower percentage is generally more favorable, indicating fewer operational costs per dollar of sales.
The operating margin expresses operating income (revenue minus operating expenses) as a percentage of revenue. A higher percentage is generally more favorable, indicating more profit generated per dollar of sales from core operations.

Essentially, if the operating ratio is, for example, 80%, then the operating margin is typically 20% (100% - 80%), assuming no other costs are included in the operating income calculation beyond what's in operating expenses. They convey the same information but from opposite perspectives: one focuses on the cost portion, the other on the profit portion of operational revenue. Both are valuable for understanding how effectively a company converts sales into operational profit before considering non-operating factors like interest and taxes.

FAQs

1. What is a good operating ratio?

A "good" operating ratio is one that is lower than industry peers and consistent with historical performance, indicating efficient cost management. For highly capital-intensive industries like railroads, an operating ratio in the mid-50s to 70s might be considered excellent, while other industries may have much different benchmarks¹.

2. How does the operating ratio relate to profitability?

The operating ratio directly impacts profitability. A lower operating ratio means a company spends less on operations to generate revenue, which generally translates to higher operating income and, subsequently, higher net profit, assuming other factors remain constant.

3. What types of expenses are included in the operating ratio?

The operating ratio includes all operating expenses, such as the cost of goods sold (COGS), selling, general, and administrative (SG&A) expenses, depreciation, and amortization. It does not include non-operating expenses like interest payments or income taxes.

4. Can the operating ratio be above 100%?

Yes, an operating ratio can be above 100%. If the ratio exceeds 100%, it means that a company's operating expenses are greater than its net sales. This indicates that the company is not generating enough revenue from its core operations to cover its operational costs, leading to an operating loss.

5. How can a company improve its operating ratio?

A company can improve its operating ratio by either increasing revenue without a proportional increase in operating expenses, or by reducing its operating expenses without significantly impacting sales. Strategies might include optimizing supply chains, negotiating better terms with suppliers, improving production efficiency, or implementing cost-cutting measures.