The working ratio compares the operating expenses of a business to its revenue. The ratio reveals whether a company can at least recover its operating expenses from sales. It is used as a general indicator of the financial health of a business, though it yields a figure that is imprecise. The ratio is most commonly used by third parties as part of their analysis of a business. The calculation of the working ratio is to divide total annual operating expenses, not including depreciation, by annual gross revenue. The formula is:
(Annual operating expenses - Depreciation expense) ÷ Annual gross revenue
If the ratio is less than 1, it implies that the business can recover its operating expenses. A ratio of greater than 1 indicates that the company cannot be profitable without significant changes to its cost structure and/or pricing.
The working ratio is not one of the more reliable performance measures, for the following reasons:
- It does not include financing costs
- It assumes that a ratio of 1 is good, when in reality, that is (at best) zero profitability
- The denominator should use net revenue, rather than gross revenue, thereby including the impact of sales returns and allowances.
- It does not account for projected changes in operating expenses.
- It assumes that cash flows exactly equate to the amounts of operating expenses and gross revenues stated in the formula, which may not be the case.
In short, the working ratio is excessively imprecise, and so is not recommended as a method for evaluating the financial condition of a business.