The expenses ratio is closely related to the profit margin, gross as well as net. For instance, if the operating profit margin is deducted from 100 per cent, the operating ratio. Alternative, when the operating ratio-is subtracted from 100 per cent, we get the operating profit margin. If the sales and total non-financial expenses of a firm are Rs 10.00,000 and Rs 32,00,000 respective, the operation ratio would he 80 per cent. It implies that total operating expenses including cost of goods sold consume 10 per cent of the left for meeting interest, tax and dividends obligations as also retaining profits for future expansion. The cost of Roods sold ratio shows what percentage share of sales is consumed by cost of goods sold and conversely, what proportion is available for meeting expenses such as selling and general distribution expenses as well as financial expenses consisting of taxes interest and dividends, and so on.
The expenses ratio is, therefore, very important for analyzing the profitability of a firm. It should be compared over a period of time with the industry average as well as firms of similar type. As a working proposition. a low ratio is favorable, while a high one is unfavorable. The implication of a high expenses ratio is that only a relatively small percentage share of sales is available for meeting financial liabilities like interest, tax and dividends, and so on. An analysis of the factors responsible for a low ratio may reveal changes in the selling price or the operating expenses. It is likely that individual items may behave differently. While some operating expenses mar show a rising trend, others may record a fall. The specific expenses ratio for each of the items of operating cost may be calculated. These ratios would identify the specific cause. To illustrate, an increase in selling expenses, may be due to a number of reasons: (i) general rise in selling expenses, (ii) inefficiency of the marketing department leading to uncontrolled promotional and other expenses, (iii) growing competition, (iv) ineffective advertising, (v) inefficient utilization of resources, and the like.
A low operating ratio is by and large a test of operational efficiency. In case of firms whose major source of income and expenses are non-operating, the operating ratio, however, cannot be used as a yardstick of profitability.
To conclude, the profitability ratios based on sales are an important indicator of the operational efficiency of a manufacturing enterprise. However, they suffer from a serious limitation in that they are not useful from the viewpoint of the owners of the firm.