If the operating ratio is below 1 that means the company is making money. The lower the operating ratio, the more efficient the company.
How to use operating ratio
- Lower is better.
- Below 1 is considered healthy but always compare the company to the industry mean.
- Can be very different between industries.
- Can be used to compare companies.
Why do investors use operating ratio in their analysis
Shows if costs of creating products and or services is increasing or decreasing. The lower the operating ratio, the more efficient the company is creating products and services.
The three steps every investor should look at:
- What is the current Operatin ratio?
- How does it compare to the industry?
- What is the trend?
Things to be aware of
- Only compare with other companies in the same industry.
- You need COGS to calculate operating ratio which is not always shown in the income statement.
- Does not consider debt.
How to calculate operating ratio
Real life example
A real life example of Tesla. You need the following data to determine operating ratio:
COGS is not specified on the income statement so we use the following calculation:
- (cost of revenue + total operating expenses) \ total revenue
- ($12,700,000 plus $1,628,000) \ $16,934,000 = 0.84
The operating ratio measures the efficiency of a company at keeping low costs while generating profits from sales. It compares the total operating expenses to the net amount of sales. The total operating expenses exists of:
- COGS (materials, labour, rent of facility, repairs)
- Operating expenses (legal fees, marketing, wages, rent, maintenance/repairs)
Operating expenses are all the costs the company makes that are not directly tied to the production of the service or product. Where COGS are costs that are directly tied to the production of a product or service.
Do note that COGS is not always available in the income statement. Some companies include COGS in the operating expenses while others list COGS separately. To make it even more confusing, COGS is also known as “costs of sales” and costs of sales is the same as costs of revenue.
The operating ratio tells you how efficient the company is creating its products or services while keeping prices low. In this case, a lower ratio is better. Higher or rising operating ratios might tell you that costs are rising while sales are not improving or staying the same.
How you think about this?