The operating ratio is a measure calculated to determine how efficiently a business is being managed by comparing their incoming cash versus outgoing cash. Similar to the burn rate, the operating ratio determines trends associated with your incoming and outgoing cash.
What is the operating ratio?
The operating ratio is the measure of efficiency that a business operates at on a day-to-day basis. This metric assesses how effective a company is at maintaining a low cost of operation while generating more revenue than its total expenditures. The operating ratio is a useful way for a business to evaluate their core operations.
The lower the ratio is, the more efficiently the organization is creating profits. On the other hand, an operating ratio that is going up means the business is gradually operating less efficiently and losing profits. According to AgDirect you should be aiming for an operating expense ratio between 70% and 80%.
Operating Ratio Formula:
The operating ratio for a business is calculated by dividing operating expenses by net sales and expressing the result as a percentage. The calculation is done as follows:
Operating Ratio = (Operating Cost ÷ Net Sales) x 100
Components of the Operating Ratio:
Included in the operating ratio are essentially all business expenses except taxes and interest payments. These expenses include:
· Administrative expenses
· Cost of goods sold
· Salary and wages
· Rent and utilities
· Sales and marketing
· Repair and maintenance
A limitation of the operating ratio is that it doesn’t include debt. If a business has taken on a large amount of debt, obligating them to make large interest payments, the debt is not factored into the operating ratio. This means that multiple businesses could have the same operating ratio with very different amounts of debt, so it is important to compare debt to get a better idea of a business’ overall finances.
How to Improve Operating Ratio
Collect, Review and Leverage Financial Data
Ensure to contextualize all your financial data. In a competitive marketplace having a clear and strong understanding of all the data moving through your business- such as finance, marketing, social media, human resources and customer service- gives you the power to analyze that data and uncover valuable insights.
Invest in Technology
Capturing, organizing and analyzing your data, and then putting the insights to good use, requires implementing a comprehensive software solution. Through the use of proper technology you will gain access to tools such as artificial intelligence, advanced data management and analytics and process automation.
As with all financial metrics, the operating ratio needs to be monitored throughout multiple reporting periods to identify if there are any trends present. It is crucial to have a firm grasp of the operating ratio to evaluate the efficiency of your business.