Is Your Business Efficient? Calculate Your Operating Ratio Today

By evaluating the relationship between operating expenses and net sales, the operating ratio provides insight into a company’s operational efficiency and financial health. Whether you’re a business owner, investor, or trader, the operating ratio plays a crucial role in guiding smarter investing and business decisions.

To help you leverage this key financial metric in your own operations and strategies, we’ve used our expertise at Business2Community to deliver everything you need to know about the operating ratio, including how to calculate it and examples.

What is an Operating Ratio?

The operating ratio, which compares a company’s total operating expenses to its revenue, is a metric used to assess operational efficiency and guide decisions related to investment, profitability, and resource allocation.

Who Needs to Do an Operating Ratio Analysis?

Key decision-makers who want to understand a company’s operational efficiency, performance, or financial position should conduct an operating ratio analysis. For example:

Investors use the operating ratio to:

• Evaluate a company’s profitability.
• Assess a company’s ability to generate profit from its core business activities.
• Evaluate a company’s operational efficiency and cost management over time.
• To compare a company’s performance to competitors within the same industry.

Business owners and managers use the operating ratio to:

• Determine a company’s operational efficiency.
• Identify areas for cost reduction.
• Streamline business processes.
• Boost profitability.
• Track company progress against goals or industry benchmarks.

Stock traders use the operating ratio to:

• Assess a company’s operational efficiency.
• Evaluate a company’s investment potential based on historical performance.
• Benchmark a company against industry peers.
• Drive more informed decisions.

Operating Ratio vs. Expense Ratio

The operating ratio is a valuable ratio for determining how well all kinds of companies across various industries generate revenue in relation to their operating costs. On the other hand, the operating expense ratio (OER), is used in the real estate industry to evaluate the costs of operating a property in relation to the income it generates. It is expressed as a ratio representing a property’s operating expense minus depreciation divided by its gross operating income.

How to Calculate an Operating Ratio

To calculate an operating ratio, divide operating expenses and cost of sales by net sales. 

We explain how to arrive at each of the components in the formula above and how to interpret your findings in the steps below.

Step 1: Get the Data

To calculate the operating ratio, get the appropriate data from a company’s financial statements. In this case, that means the figures for operating expenses and net sales.

Let’s start with net sales.

Net Sales

Net sales refers to the total revenue generated by a company minus any returns, allowances, and discounts. It is usually the top line of a company’s income statement.

Operating Expenses

Operating expenses are the costs related to the day-to-day running of the business. They are not directly tied to production and exclude non-operating costs such as interest payments or one-time charges. Instead, operating costs typically include:

• Cost of goods sold (COGS) – These are the direct costs incurred in the production of goods and services sold by a company.
• Selling, general, and administrative expenses (SG&A) – These are fixed costs such as rent, marketing, insurance, payroll, and other administrative costs.

These costs are found in a company’s income statement, which shows income, expenses, and profitability over a period of time.

On the income statement, the cost of goods sold (COGS) is often the second line item below the revenue line. The operating expenses section can be found further down, right below gross profit.

To determine operating expenses, add the total cost of sales and total operating expenses together.

Step 2: Do the Calculation

Once you have the right figures, simply plug them into the operating ratio formula given earlier:

Operating ratio = (Operating expenses + Cost of goods sold / Net sales) x 100

You should get a percentage amount that tells you how much of each dollar of sales is spent on operating costs. For example, if your operating ratio is 75%, this means that you spend 75 cents on operating expenses for each dollar of revenue your company generates. The remaining 25 cents is what is left to cover non-operating expenses, pay dividends, and contribute to the company’s net income or retained earnings.

Step 3: Interpret the Result

The final step involves interpreting the operating ratio to uncover actionable insights and guide more informed decision-making.

Due to different operating structures and cost dynamics, what is considered a good operating ratio varies from industry to industry. Generally, a lower operating ratio is considered more favorable, as it implies that a company has higher operational efficiency or that it can generate more revenue relative to its operating expenses.

A higher operating ratio suggests that a company’s operations may be inefficient, leading to a significant portion of revenue being consumed by operating costs. As a general guideline:

• Excellent: Below 50%
• Good: 50% – 80%
• Concerning: Above 80%

To get a clearer picture of your company’s operational efficiency, consider calculating the operating ratio over several years. Here, a decreasing operating ratio is a positive sign representing efficiency and profitability, while a consistent upward trend is a negative sign pointing to inefficiency or potential financial strain.

For greater context, compare your operating ratio with industry benchmarks. What is your company’s operating ratio relative to other similar companies in your industry? If it is lower than average, your company has an advantage in managing its operating expenses. Conversely, an above-average ratio may signal trouble and require urgent interventions.

Examples of an Operating Ratio

Below, we illustrate how to calculate and interpret the operating ratio of two companies.

Example 1: Calculating Apple’s Operating Ratio

Initially, you need to get the data from the company’s accounts, so if you’re a trader or investor trying to decide if an investment in Apple is worth it, you will need to look at the public account filings for the company.

Based on Apple’s consolidated annual financial statements for 2023, its operating expenses, COGS, and net sales spanning three years are as follows:

Operating expenses:

• 2023: $54,847 million
• 2022: $51,345 million
• 2021: $43,877 million

Cost of goods sold:

• 2023: $214,137 million
• 2022: $223,546 million
• 2021: $212,981 million

Net sales:

• 2023: $383,285 million
• 2022: $394,328 million
• 2021: $365,817 million

With the information in hand, you can now do the calculation using the operating ratio formula to find Apple’s operating ratio for 2021, 2022, and 2023:

Operating ratio = (Operating expenses + Cost of goods sold / Net sales) x 100

• 2023 operating ratio = ((54,847 + 214,137) / 383,285) x 100 = 70.18%
• 2022 operating ratio = ((51,345 + 223,546) / 394,328) x 100 = 69.71%
• 2021 operating ratio = ((43,877 + 212,981) / 365,817) x 100 = 70.22%

From the findings,  you can interpret the results to see that Apple’s operating ratio remained relatively stable at around 70% over three years, indicating that the company effectively managed its operating expenses relative to its revenue. However, further analysis and benchmarking are needed to gain deeper insight into Apple’s competitiveness and key areas for improvement.

Example 2: Calculating Tesla’s Operating Ratio

In this example, we’ll look into Tesla’s operating ratio. First, you need to get the data by downloading the financial reports you want to scrutinize from the investor relations portion of the Tesla company website.

Based on Tesla’s consolidated annual financial statements for 2023, its operating expenses, COGS, and net sales spanning three years are as follows:

Operating expenses:

• 2023: $8,769 million
• 2022: $7,197 million
• 2021: $7,083 million

Cost of goods sold:

• 2023: $79,113 million
• 2022: $60,609 million
• 2021: $40,217 million

Net sales:

• 2023: $96,773 million
• 2022: $81,462 million
• 2021: $53,823 million

Now, we can do the calculation using the operating ratio formula to find Tesla’s operating ratio for 2021, 2022, and 2023:

Operating ratio = (Operating expenses + Cost of goods sold / Net sales) x 100

• 2023 operating ratio = ((8,769 + 79,113) / 96,773) x 100 = 90.81%
• 2022 operating ratio = ((7,197 + 60,609) / 81,462) x 100 = 83.24%
• 2021 operating ratio = ((7,083 + 40,217) / 53,823) x 100= 87.88%

From the findings, we can interpret the results and see that Tesla’s operating ratio fluctuated between 83% and 90% over three years, suggesting that the company spent a significant portion of its revenue on operating expenses. This is a bit concerning and should be investigated further,  but it may not be a massive problem.

Again, more analysis and benchmarking are advisable to gain deeper insight into Tesla’s financial standing and key areas for improvement.

How to Adjust an Operating Ratio

To adjust your operating ratio and improve your outcomes, consider making the following changes to your business:

• If your operating ratio seems to be increasing over time, implement cost-control measures across key departments to improve your margins. For example, you could negotiate better deals with your suppliers or automate certain processes to reduce labor expenses.
• Explore ways to increase your company’s revenue, including adjusting your prices, expanding into new markets, and increasing sales volumes through more effective promotional and marketing strategies.

Limitations of Operating Ratios

While valuable, the operating ratio has certain limitations. Firstly, it excludes debt and therefore provides a limited view of a company’s financial position. For example, a company might appear efficient based on its operating ratio but have significant debt eroding its overall profitability.

To address this limitation, it must be supplemented with debt leverage and solvency ratios such as debt-to-equity and interest coverage. These ratios give a clearer picture of a company’s debt burden and its ability to handle interest payments.

The operating ratio provides insights into operational efficiency, not overall financial health. For a more comprehensive analysis of a company’s financial health, it must be combined with other financial metrics such as liquidity ratios, profitability ratios, and leverage ratios. This provides sufficient financial data to make sound decisions about investment, cost management, and resource allocation.

For even deeper insights, market analysis and other qualitative frameworks such as SWOT or PESTEL can be used to assess a company’s competitive standing and prospects.

The Value of the Operating Ratio

As it focuses on a company’s core business activities, the operating ratio is a valuable metric for evaluating company efficiency. By determining how well a company manages its expenses relative to revenue generation, it offers powerful insights for decision-makers.

If you’re a business owner or manager, you can leverage this efficiency ratio to guide strategic resource allocation, cost management, and profitability decisions. If you’re a trader or investor, you could use the operating ratio as part of fundamental analysis or to compare companies and identify key performance trends.

For more comprehensive and actionable insights, combine your operating ratio analysis with other financial metrics, market research, and qualitative frameworks like PESTEL analysis to assess overall financial performance relative to key market factors and dynamics.

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