Operating ratio is a financial metric that establishes a relationship between the operating profit of a company and its net sales. It is used to determine the revenue earned by a firm after bearing all its operating expenses, i.e., the expenses necessary to run a business. This ratio is used to determine the earning efficiency of the firm.
Operating Profit Ratio is one of the profitability ratios in accounting theory and practice. Profitability ratios are the financial metric employed in order to measure a firm’s ability to generate earnings. Accounting ratios that are used to measure the profitability of the business are known as Profitability Ratios.
- Operating Profit: Operating profit is the residual income left after deducting all the operating expenses from the net revenue earned by the business during an operating cycle. Operating expenses are those expenses that are relevant to the day-to-day operations of the business and recurring in nature.
- Net Sales: It refers to the revenue earned by the firm by selling its products after adjusting all kinds of sales returns, discounts, allowances to the customers, etc.
- Non-operating Expenses: Expenses that are not incurred to earn profit are called non-operating expenses. E.g., Interest on Long-term Borrowings, Loss on Sale of Fixed Assets, etc.
- Non-operating Incomes: Incomes that are not earned from the operating activities of the business are called Non-operating Incomes. E.g., Interest on Investment, Gain on Sale of Non-current Assets, etc.
Formula:
Where,
Operating Profit = Net Sales – Cost of goods sold – Administrative Expenses – Selling and Distribution Expenses
or
Operating Profit = Gross Profit + Other Operating Income – Other Operating Expenses
or
Operating Profit = Net Profit (Before Tax) + Non-Operating Expenses/Losses – Non-Operating Incomes
or
Operating Profit = Revenue from Operations – Operating Cost
Revenue from Operations (Net Sales) = Gross Revenue – Sales Return – Discount – Allowances
or
Revenue from Operations (Net Sales) = Cost of Revenue from Operations + Gross Profit
Significance:
The operational efficiency of the business is measured by the Operating Profit ratio. Management is considered efficient when the ratio is higher and an improvement in the ratio over the previous period shows an improvement in the operational efficiency of the firm. The operating ratio and operating profit ratio are complementary to each other, which means that the higher the operating profit ratio, the lower the operating ratio. Both are calculated in percentage form.
Illustration 1:
Calculate the Operating Profit Ratio of GFG Ltd. from the following information:
Solution:
Operating Profit = Revenue from Operations – Cost of Goods Sold – Office and Administration Expenses – Selling and Distribution Expenses
= 50,00,000 – 25,00,000- 2,50,000 – 5,00,000
= ₹17,50,000
Revenue from Operations (Net Sales) = ₹17,50,000
Operating Profit Ratio = 35%
Illustration 2:
Compute the operating profit ratio from the following information:
Operating Cost ₹4,00,000; Operating Expenses ₹35,000; Gross Profit Ratio 25%.
Solution:
Operating Cost = Cost of Goods Sold + Operating Expenses
Therefore, Cost of goods sold = Operating Cost – Operating Expenses
= 4,00,000 – 35,000
= ₹ 3,65,000
Also, Revenue from Operations = Cost of Goods Sold + Gross Profit
Let net sales be x. Then gross profit =
Revenue from operations = ₹4,86,667
Operating Profit = Revenue from Operations – Operating Cost
= ₹4,86,667 – 4,00,000
= ₹86,667
Now,
Operating Profit Ratio = 17.81%