An operating ratio is a mathematical calculation used to determine a company’s operational efficiency. The traditional operating ratio compares the company’s operating expenses to its net sales. Total net sales are calculated by taking gross sales revenues minus sales returns, discounts, and allowances. This ratio helps companies determine how well they can generate sales revenues based on the expenditures during a specific time frame. The information for this financial ratio is usually contained on a company’s income statement.
The operational ratio is expressed as a percentage calculated by dividing a company’s operating expenses by its net sales. The resulting figure can provide insight on how well the company will generate profit if revenues decrease or expenses increase. For example: a company with monthly operating expenses of $100 million United States Dollars (USD) and $500 million USD in net sales will have an operating ratio of 20%. In general, the smaller the ratio calculation, the better opportunity the company will have to generate profits.
Another way to look at the operating ratio is by figuring the amount of money that must be generated to pay for operating expenses. Many companies often use basic gross profit ratios when calculating their profit percentage. This formula can be calculated by taking net sales minus cost of goods sold, divided by net sales. The resulting figure is also expressed in a profit percentage for items sold by the company. If companies desire to maintain a certain profit percentage, they will combine the original operating ratio and gross profit ratio to create a more enhanced mathematical calculation.
A hybrid operational ratio is cost of goods sold plus operating expenses, divided by net sales. This operational ratio determines how well a company covers all expenditures during an accounting time period. Similar to the original formula, the smaller percentage calculation usually means companies are generating higher profits compared to cost of goods sold and operational expenses.
Companies can also use other operating ratios to determine the effectiveness and efficiency of their operations. Other types of operating ratios include net worth and operating leverage calculations. The net worth ratio indicates how much economic value the company has added from operations. The operating leverage ratio provides information regarding how much external debt or equity the company uses to run business operations.
Financial ratios provide companies with benchmarks to use as comparison tools in the business environment. Companies can calculate their ratios and compare the results against a leading company or the industry standard. This comparison may lead directors or managers to conduct a deeper analysis of business operations and discover how their company can improve their operational ratios.