The operating expense ratio is just one measurement of a company's performance. While it fails to provide complete insight into a company's financial health without the aid of other metrics such as free cash flow, price-to-earnings ratio and overall revenue growth over time, it does provide a quick reference for the company's overall profit margin.
The operating expense ratio is calculated by dividing total operating expenses by net sales. Operating expenses are defined as the normal costs of running the businesses and exclude special expenses like repurchase of stock or large capital investments. For instance, a company with operating expenses of $20 million and net sales of $35 million has an operating ratio of 0.57. Net sales are calculated by subtracting any special allowances given to customers, returns, or other deductions from total sales.
The operating expense ratio is one measure of how efficient a company is. Said another way, it indicates how much each dollar in sales revenue cost the company to achieve. An operating expense ratio of 0.63 means that for every dollar of sales, the company spent 63 cents to create the sale. One of the most important considerations with this ratio is the direction is takes over time. An expense ratio that is increasing over time means the company is operating less efficiently from period to period.
The ideal operating expense ratio will vary between industries, but generally a company can be compared to other companies in like condition in order to obtain a benchmark of their performance. Another key consideration is whether the company's expense ratio increases as sales increase. For instance, if the operating expense ratio is 0.45 at the current level of sales, then if sales increase by 10 percent next period but the ratio remains 0.45, the company has been able to realize 10 percent more revenue without increasing cost.
The operating expense ratio provides a dimension of insight into the company's core profitability because it measures profit margins based on the total cost of the business, not just the gross margin per unit sold. However it fails to paint a holistic picture of the company's health. Other important factors should be considered, including total revenue, operating margin, net sales, liquidity, days in accounts payable and accounts receivable and inventory position. Generally, an operating expense ratio that is decreasing over time while other important metrics remain strong is an indicator of a company that is growing more efficient and successful.
