For entrepreneurs looking to open a small or family-owned business, two things are critical: An idea and money. What are you going to sell and how are you going to get what you need to sell it? What do you do later when you need more money to expand or grow the business?
Your business's operating ratio is the key to answering these questions.
What's an Operating Ratio?
Basically, the operating ratio is a mathematical formula used to show how your business if doing. It shows whether a business making or losing money, or breaking even. The formula is cost of the goods sold + operating expenses ÷ net sales:
- Cost of goods sold includes things like raw material costs and labor for making the goods
- Operating expenses are all costs you have in the day-to-day operation of the business not connected to making the goods you sell. Payroll, sales commissions, rent, equipment repairs and taxes are good examples
- Net sales are the total sales minus things like returned, damaged or missing items. They're the actual, full-price, final sales made
An ideal operating ratio is low, below 1. Below 1, you're making money. If it equals 1, you break even. Above 1, you lose money. The key is to keep net sales higher than the cost of goods sold and operating expenses.
For example, say you have $200,000 in net sales, $75,000 in costs of goods sold, and $25,000 in operating expenses. Your company's operating ratio is 0.5 (($75,000 + $25,000) ÷ $200,000), and you're making money. If, in the same example, your net sales were only $100,000, then your ratio is 1, and you're breaking even.
As an entrepreneur looking to start a new small business, you're probably asking why this important right now? And, how do you figure out a ratio before you're open for business? First of all, having an idea of what your costs, expenses and sales might be can help you figure out how much start-up money you'll need. Knowing the ratio helps with securing investors. Your business plan, should have good estimates of your costs and expenses, as well as projected or expected sales. Showing a ratio near or below 1 helps attract investors, including friends and family.
The ratio can be more important when expanding your business. A good operating ratio shows potential investors, especially venture capitalists, business success, and it's worth the investment risk. This can be critical to business growth and continued success. These financing types can matter when other financing, like bank loans lines of credit, aren't an option.
Questions for Your Attorney
- Are there any legal consequences if information in my business plan is wrong and my investors lose money?
- I'm thinking about buying a small business. How can I be sure the seller's accounting books are accurate?
- What are the pros and cons of dealing with venture capitalists?