Show pageOld revisionsBacklinksBack to top This page is read only. You can view the source, but not change it. Ask your administrator if you think this is wrong. ======Operating Ratio (OR)====== The Operating Ratio (OR) is a simple yet powerful tool that measures a company's operational efficiency. Think of it as a "cost-to-sales" scorecard for a business's core activities. It calculates what percentage of a company's revenue is eaten up by its day-to-day operational costs. The formula is straightforward: [[Operating Expenses]] divided by [[Net Sales]]. A lower ratio is almost always better, as it signals that the company is keeping a tight rein on its costs and converting more of its sales into profit. Unlike broader profitability metrics, the OR laser-focuses purely on the costs of running the main business, deliberately ignoring non-operational factors like [[interest expense]] and taxes. This purity makes it an excellent gauge of management's effectiveness at its primary job: running the company efficiently. For a [[value investor]], a business with a consistently low and stable Operating Ratio is often a sign of a well-managed enterprise with a strong competitive footing. ===== Why the Operating Ratio Matters to Value Investors ===== Value investors are obsessed with finding high-quality businesses that can generate sustainable profits over the long term. The Operating Ratio is a direct window into this quality. A company that can consistently maintain a low OR compared to its peers likely possesses a significant [[competitive advantage]], what [[Warren Buffett]] famously calls a "moat." This could stem from superior technology, economies of scale, a strong brand, or simply exceptionally lean management. This operational efficiency is the bedrock of financial health. Why? * **Higher Profitability:** Every dollar saved on operations is a dollar that can flow down to the bottom line, boosting profits. * **Resilience:** An efficient company is better equipped to survive economic downturns or price wars. It has more wiggle room before it starts losing money. * **Sustainable [[Free Cash Flow]]:** Efficient operations are the engine that generates the cash needed to reinvest in the business, pay dividends, or buy back shares—all things that create shareholder value. A low and predictable OR suggests a business isn't just surviving; it's thriving. It's a hallmark of a company that knows what it's doing and does it exceptionally well. ===== Breaking Down the Formula ===== Understanding the OR is all about knowing what goes in and what stays out. //Operating Ratio = Operating Expenses / Net Sales// ==== The Numerator: Operating Expenses ==== This includes all the costs required to keep the lights on and run the core business. It’s typically the sum of two major categories found on the [[income statement]]: * **[[Cost of Goods Sold (COGS)]]:** The direct costs of producing the goods or services the company sells. For a bakery, this is flour and sugar; for a carmaker, it's steel and tires. * **[[Selling, General & Administrative (SG&A) Expenses]]:** All other operational costs, including salaries for executives and sales staff, marketing budgets, rent for office space, and utility bills. Crucially, Operating Expenses **exclude** items not related to the core business operations, such as interest on debt, investment gains or losses, and income taxes. This is what makes the OR such a pure measure of operational health. ==== The Denominator: Net Sales ==== This is the company's "top-line" revenue after subtracting returns, allowances for damaged goods, and any discounts offered. It represents the total money generated from customers for the company's primary products or services. A quick tip: The Operating Ratio is the inverse of the [[Operating Margin]]. If a company has an Operating Ratio of 80%, its Operating Margin is 20% (100% - 80%). Both tell the same story about efficiency, just from different angles. ===== Putting It Into Practice: A Value Investor's Checklist ===== A single OR number in isolation is not very useful. The real insight comes from context and comparison. ==== Comparing Apples to Apples ==== The Operating Ratio varies dramatically between industries. A supermarket chain (high volume, thin margins) might have an OR of 95%, while a software company (low marginal costs) might have an OR of 65%. Neither is inherently "good" or "bad" on its own. The magic happens when you compare a company's OR to its direct [[competitors]]. If Company A has an OR of 75% and its closest rival, Company B, has one of 85%, it's a strong indicator that Company A is the more efficient operator in that industry. ==== Spotting Trends Over Time ==== The most powerful use of the OR is to track it over a multi-year period (e.g., 5-10 years). * **A decreasing trend** is a fantastic sign. It shows that management is getting better at controlling costs or that the company's scale is providing a cost advantage. * **A stable, low trend** is also excellent. It suggests a durable, predictable business model. * **An increasing trend** is a red flag. It could signal eroding margins, intensifying competition, or sloppy management. It's a signal to dig deeper. ==== The Bigger Picture ==== The OR is a sharp tool, but it's not the only one in the shed. Always use it as part of a holistic analysis. Check it alongside other key metrics to get a complete picture of a company's financial health: * **[[Gross Margin]]** * **[[Net Profit Margin]]** * **[[Return on Equity (ROE)]]** * The strength of the [[balance sheet]] (especially debt levels) ===== A Word of Caution ===== While incredibly useful, the OR isn't foolproof. Be aware that: * It doesn't tell you anything about how a company finances its operations (debt vs. equity). * It doesn't capture the cash required for [[capital expenditures (CapEx)]], which is the cost of maintaining and growing the physical asset base. A company might have a great OR but be underinvesting in its future. * Accounting choices can sometimes affect how expenses are classified, potentially distorting the ratio in the short term. This is another reason why long-term trend analysis is so important. ===== The Bottom Line ===== The Operating Ratio is a wonderfully straightforward metric that cuts through the noise to tell you how efficiently a company is running its core business. For the disciplined [[value investor]], it's more than just a number; it’s a story about management competence and competitive strength. A company that consistently demonstrates a low and stable Operating Ratio is a company that has its house in order—exactly the kind of durable, high-quality business you want to own for the long run.