====== Operating Ratio ======
The operating ratio is a financial metric that measures a company's operational efficiency by comparing its operating expenses to its [[Net Sales]]. Think of it as a report card on how well a company manages its day-to-day costs. The formula calculates what percentage of sales revenue is eaten up by the costs of running the business, //before// accounting for non-operational items like interest payments and taxes. A lower operating ratio is generally better, as it indicates that a company is keeping a tight rein on its expenses and converting more of its sales into profit. For [[value investing]] disciples, a low and stable operating ratio can be a beautiful sight, often signaling a well-run business with a strong competitive footing.
===== How to Calculate the Operating Ratio =====
Calculating this ratio is straightforward, and the data you need can be found right in a company's [[income statement]].
==== The Formula ====
The classic formula is:
//Operating Ratio = (Operating Expenses + [[Cost of Goods Sold (COGS)]]) / Net Sales//
Let's break down the ingredients:
  * **Operating Expenses**: These are the costs required for the normal course of business, but not directly related to producing a product. Think of things like salaries for the marketing team, office rent, utility bills, and [[Selling, General & Administrative Expenses (SG&A)]].
  * **Cost of Goods Sold (COGS)**: This represents the direct costs of production. For a baker, it's the flour and sugar; for a carmaker, it's the steel and tires.
  * **Net Sales**: This is the company's total [[Revenue]] from sales, minus any returns, allowances for damaged goods, and discounts.
==== A Quick Example ====
Imagine you're analyzing a fictional company, "Efficient Engines Inc." For the last year, their books show:
  * Net Sales: $1,000,000
  * COGS: $400,000
  * Operating Expenses: $250,000
Plugging these into the formula:
  - **Step 1**: Add COGS and Operating Expenses: $400,000 + $250,000 = $650,000
  - **Step 2**: Divide by Net Sales: $650,000 / $1,000,000 = 0.65
Efficient Engines has an operating ratio of 0.65, or 65%. This means for every dollar in sales, it spends 65 cents on its core operations.
===== Why Should a Value Investor Care? =====
This isn't just an abstract number; it's a powerful clue about the quality and durability of a business.
==== A Window into Efficiency ====
The operating ratio is a direct reflection of [[management]]'s ability to control costs. A company with a consistently low ratio compared to its peers often has a superior business model or a significant operational advantage. Legendary investor [[Warren Buffett]] has always been fond of low-cost operators because they can withstand price wars and economic downturns better than their bloated competitors. A downward trend in the operating ratio over several years is a fantastic sign, suggesting management is getting even better at its job.
==== Comparing Apples to Apples ====
Context is everything. You can't compare the operating ratio of a railroad company (which has massive fixed costs) to a software firm (which has very different expenses). The ratio's true power is unlocked in two ways:
  * **Industry Comparison**: How does your company's ratio stack up against its direct competitors? A significantly lower ratio can point to a [[competitive advantage]].
  * **Historical Comparison**: How has the company's own ratio changed over the past 5-10 years? A steady or improving ratio suggests stability and discipline, while a rising ratio could be a red flag that costs are spiraling out of control.
===== Operating Ratio vs. Operating Margin =====
It's easy to mix up the operating ratio with its close cousin, the [[operating margin]]. They are two sides of the same coin, measuring the same thing (operational performance) from different angles.
  * The **Operating Ratio** tells you how much //costs// take out of a dollar of sales. (Lower is better).
  * The **Operating Margin** tells you how much //profit// is left from a dollar of sales after those same costs. (Higher is better).
In fact, they are mathematically linked: //Operating Margin = 1 - Operating Ratio//.
In our Efficient Engines example, the operating ratio was 65%. Therefore, its operating margin is 1 - 0.65 = 0.35, or 35%. While both metrics lead you to the same conclusion, the operating ratio keeps your focus squarely on the expense side of the ledger, making it a favorite for investors who are obsessed with cost control.