OPRATING RATIO

The operating ratio is determined by comparing the cost of the goods sold and other operating
expenses with net sales.

Formula:

Following formula is used to calculate operating ratio:

[(Cost of goods sold + Operating expenses / Net sates)] 100

Here cost of goods sold = Operating stock + Net purchases + Manufacturing expenses - Closing
stock

OR

= Net sales - Gross profit

Operating expenses = Office and administrative expenses + Selling and distribution expenses

Interpretation:

This ratio is a test of the efficiency of the management in their business operation. It is a means
of operating efficiency. In normal conditions, the operating ratio should be low enough so as to
leave portion of the sales sufficient to give a fair return to the investors.

Operating ratio plus operating profit ratio is 100. The two ratios are obviously interrelated. For
example, if the operating profit ratio is 20%, it means that the operating ratio is 80%. A rise in
the operating ratio indicates a decline in the efficiency.

Lower the operating ratio, the better is the position because greater is the profitability and
management efficiency of the concern. The higher the ratio, the less favorable is the situation,
because there will be smaller margin of profit available for the purpose of payment of dividend
and creation of reserves

EXPENSE RATIO
Definition and Explanation:

Expense ratios are calculated to ascertain the relationship that exists between operating expenses
and volume of sales. Expense ratios are calculated by dividing each item of expense or group of
expenses with the net sales so analyze the cause of variation of the operating ratio. It indicates
the portion of sales which is consumed by various operating expenses.

Formula:

Ratio of material used to sales: (Direct material cost / Net sales) 100

Ratio of labor to sales: (Direct labor cost / Net sales) 100

Ratio of factory overheads to sales: (Factory expenses / Net sales) 100

Ratio of office and administration expenses to sales: (Office and administration expenses /
Net sales) 100

Ratio of selling and distribution expenses to sales: (Selling and distribution expenses / Net
sales) 100

These ratios are expressed in terms of percentage. The total of the above ratios will be equal to
the operating ratio.

The total revenue expenditure may be sub-divided into two categories with fixed and variable. In
the case of a fixed expense, the ratio will fall with increase in sales and for a variable expense,
the ratio in proportion to sales shall nearly remain the same.

Example:

Definition and Explanation:

Inventory turnover ratio or Stock turnover ratio indicates the velocity with which stock of
finished goods is sold i.e. replaced. Generally it is expressed as number of times the average
stock has been "turned over" or rotate of during the year.

A slow inventory movement has the following disadvantages:

Blocking of scarce funds which could be gainfully employed elsewhere;

Requiring more strong space resulting in higher maintenance and handling costs;

Chances of product being outdated or out of fashion especially in case of consumer goods;

During storage for excessive period quality may deteriorate due to inherent factors like rusting
loss of potency etc.

Similarly insufficient level of inventory is also dangerous because it may be responsible for the
loss of business opportunity. Thus for each item of stock minimum average and maximum levels
should be fixed carefully.

Formula:

Following formula is used to calculate this ratio:

Cost of goods sold / Average inventory at cost

Where Cost of goods sold = Sales - Gross profit or + Gross loss

or

Opening stock + Net purchases + Direct Expenses - Closing stock

and

Average inventory = (Opening stock + Closing stock) / 2

However in the absence of required information any one of the following formula may be
substituted as:

Inventory turnover ratio = Net sales / Average inventory at cost

or

Net sales / Average inventory at selling price

or
Net sales / Inventory