Operating ratios compare the operating expenses and assets of a business to several other performance benchmarks. The intent is to determine whether the amount of operating expenses incurred or assets used is reasonable. If not, management can take steps to prune back on certain expenses or assets. The exact specifications of these ratios will vary, depending on the line items used in a company’s financial statements.
Operating Ratio is a ratio that shows the efficiency of a company’s management by comparing operating expense to net sales. Calculated as:
Examples of the more common operating ratios are:
- Operating assets ratio. Compares the assets used to generate revenues to total non-cash assets. The intent is to eliminate those assets not contributing to operational performance, which reduces the total asset base of a business.
- Operating expenses to sales. Compares the amount of operating expenses incurred to a given sales level. The result is usually tracked on a trend line, to see if the proportion is changing over time. The analysis does not always work, since many operating expenses are fixed, and so do not vary directly with sales.
- Net profit percentage. Compares after-tax profits to sales. This is an indirect measure of operating expenses, since the percentage also includes the cost of goods sold, financing costs, and income taxes.
- Sales per employee. Compares full-time equivalent headcount to sales. This is used in environments where employees are deeply involved in sales, so there is a direct relationship between headcount and sales. The ratio is included here, because the cost of compensation can comprise a large part of total operating expenses.
All of these ratios use aggregated operating expenses, and so do not provide any insights into trends in specific expenses. Consequently, it is necessary to drill down well below the level of each ratio to determine the nature of a problem, and how to correct it.