What Is the Operating Ratio?

The operating ratio shows the efficiency of a company's management by comparing the total operating expense (OPEX) of a company to net sales. The operating ratio shows how efficient a company's management is at keeping costs low while generating revenue or sales. The smaller the ratio, the more efficient the company is at generating revenue vs. total expenses.

KEY TAKEAWAYS

The operating ratio shows the efficiency of a company's management by comparing the total operating expense of a company to net sales.

An operating ratio that is decreasing is viewed as a positive sign, as it indicates that operating expenses are becoming an increasingly smaller percentage of net sales.

A limitation of the operating ratio is that it doesn't include debt.

What Does the Operating Ratio Tell You?

Investment analysts have many ways of analyzing company performance. Because it concentrates on core business activities, one of the most popular ways to analyze performance is by evaluating the operating ratio. Along with return on assets and return on equity, it is often used to measure a company's operational efficiency. It is useful to track the operating ratio over a period of time to identify trends in operational efficiency or inefficiency.

An operating ratio that is going up is viewed as a negative sign, as this indicates that operating expenses are increasing relative to sales or revenue. Conversely, if the operating ratio is falling, expenses are decreasing, or revenue is increasing, or some combination of both. A company may need to implement cost controls for margin improvement if its operating ratio increases over time.

Limitations of the Operating Ratio

A limitation of the operating ratio is that it doesn't include debt. Some companies take on a great deal of debt, meaning they are committed to paying large interest payments, which are not included in the operating expenses figure of the operating ratio. Two companies can have the same operating ratio with vastly different debt levels, so it is important to compare debt ratios before coming to any conclusions.

As with any financial metric, the operating ratio should be monitored over multiple reporting periods to determine if a trend is present. Companies can sometimes cut costs in the short term, thus inflating their earnings temporarily. Investors must monitor costs to see if they're increasing or decreasing over time while also comparing those results to the performance of revenue and profit.

It's also important to compare the operating ratio with other firms in the same industry. If a company has a higher operating ratio than its peer average, it may indicate inefficiency and vice versa. Finally, as with all ratios, it should be used as part of a full ratio analysis, rather than in isolation