A net operating ratio is a calculation that aids in evaluating the relationship between a company’s operating expenses and its total revenue. The basic formula takes into account all the revenue generated by the business, both from sales and from holdings such as property or other investments. The cost of operating the business is then deducted from that figure, and the resulting amount divided by the total revenue. This provides the net operating ratio in the form of a percentage that helps to indicate how efficiently the business is managing the resources available.
To understand how a net operating ratio functions, consider a business operation that has total revenue for one calendar month of $50,000 US Dollars (USD). During that same period, the total figure of business expenses came to the amount of $30,000 USD. Subtracting the expenses from the total revenue results in a net figure of $20,000 USD that is then divided by the total revenue for the period. This results in a positive percentage of 40%, indicating a healthy balance between net revenue and general operating costs. Should the expenses actually exceed the total revenue, this would result in a negative operating ratio and indicate that immediate steps should be taken if the company is to survive.
Monitoring the net operating ratio is important to the continued profitability of a company. In the event that the ratio should slip below a certain level, this can be a sign that the incidence of waste in the operation is increasing, or that the revenue generated by the company is beginning to decrease. In either scenario, determining the net operating ratio provides a clear indication of whether or not something is happening that is adversely affecting the business, making it possible for owners and managers to identify exactly what is wrong and take the steps to correct the problems before the business is severely damaged.
It is not unusual for businesses of all sizes and types to calculate the net operating ratio at the end of each billing period. Even non-profit organizations can use this method to assess whether or not the revenue streams is being used to cover expenses in an efficient manner. As an internal means of assessing the financial status of the business, the net operating ratio can demonstrate that current initiatives are strengthening the company or that some aspect of the operation needs to be evaluated more closely before the business can continue to move forward.