The working ratio is used to determine whether or not a company is able to recover its operating costs from its annual revenue.
A company with a working ratio of less than one is able to recover its operating costs, whereas a ratio of more than one indicates a company that is unable to recover its costs. A ratio of one occurs when a company’s annual gross income is equal to its total expenditure.
How is it calculated?
A company’s working ratio may be determined by dividing its annual expenses (excluding depreciation and debt expenses) by its annual gross income. Annual gross income is calculated by subtracting the cost of goods, services and inventory sold from total revenue.
|Annual gross income
|Total annual expenses
Looking at the above example, company ABC appears to be in much better shape than company DEF. DEF’s working ratio of 1.03 indicates that the company is not able to recover its operating costs, which exceed its annual income. ABC, on the other hand, is very healthy, with an annual income of more than double its operating expenses. It is important to limit comparison of working ratio to companies belonging to the same industry.
Points to consider
A variation on the working ratio is working capital, which is calculated as:
Whereas the working ratio indicates a company’s ability to recover its operating costs, working capital indicates its ability to meet current obligations with short-term assets.