Operating Profit Ratio, Definition, Formula, and Calculation

Operating Profit Ratio: In business, it is very important to know how much money a company earns from its normal activities. A company may earn from selling products or services and may also earn from other sources, like investments. But the main focus is always on how much profit the company makes from its core operations. This is where the operating profit ratio becomes useful.

The operating profit ratio shows the connection between operating profit and net sales. It helps in understanding how efficiently a business is working. Commerce students often study this topic in detail because it explains a lot about the health of a business.

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What is Operating Profit Ratio?

The operating profit ratio is a type of profitability ratio. It tells us how much profit a business earns from its normal operations, after subtracting all operating expenses.

Operating profit is also known as EBIT, which means Earnings Before Interest and Taxes. Net sales include both cash sales and credit sales. By comparing operating profit with net sales, the operating profit ratio shows how much of the sales actually turned into profit.

This ratio is always expressed as a percentage. A higher percentage means the company is managing its costs well, while a lower percentage means the company is spending more on its operations.

Operating Profit Ratio Formula

The operating profit ratio is calculated with the help of a simple formula:

There are three ways to find Operating Profit,

• Operating Profit = Gross Profit – Operating Expenses
• Operating Profit = Net Profit + Non-Operating Expenses – Non-Operating Incomes
• Operating Profit = Net Sales – (Cost of Goods Sold + Administrative Expenses + Selling and Distribution Expenses)

This shows that there are different ways of finding operating profit, but the idea remains the same. Once operating profit is found, it is divided by net sales and multiplied by 100 to get the ratio.

Components Used in Formula

To calculate the operating profit ratio, we need to understand its main components.

Operating Profit: It is the profit earned from business activities like selling goods and services. It excludes incomes that are not related to operations, such as interest received or rent received.

Net Sales: It is the revenue earned by selling products or services. Net sales include both cash and credit sales. Returns and discounts are subtracted to find the actual figure.

Operating Expenses: These are the costs needed for running the business daily. They include administrative expenses, office expenses, selling expenses, and distribution expenses

Steps to Calculate Operating Profit Ratio

Below, we’ve mentioned that the calculation of the operating profit ratio can be done step by step in a simple manner:

Step 1: Find the Gross Profit.

Step 2: Calculate Operating Expenses such as administrative, office, selling, and distribution expenses.

Step 3: Subtract Operating Expenses from Gross Profit to get Operating Profit.

Step 4: Find the Net Sales of the business.

Step 5: Apply the formula: Operating Profit Ratio = Operating Profit ÷ Net Sales × 100

Operation Profit Ratio Example

Below, we’ve mentioned the calculation of the operating profit ratio with a simple example.

Question: From the following details of Green Joy Enterprise, calculate the operating profit ratio.

• Net Sales = ₹1,00,000
• Gross Profit = ₹1,50,000
• Administration Expenses = ₹50,000
• Selling Expenses = ₹30,000

Solution: Step 1: Find the Operating Expenses
Operating Expenses = Administration Expenses + Selling Expenses
= ₹50,000 + ₹30,000
= ₹80,000

Step 2: Find the Operating Profit
Operating Profit = Gross Profit – Operating Expenses
= ₹1,50,000 – ₹80,000
= ₹70,000

Step 3: Apply the Formula
Operating Profit Ratio = Operating Profit ÷ Net Sales × 100
= ₹70,000 ÷ ₹1,00,000 × 100
= 70%

Answer: The operating profit ratio is 70%.

Importance of Operating Profit Ratio

The operating profit ratio is very useful for both business owners and investors. It gives a clear picture of how well a company is managing its operations. Below, we’ve mentioned some key points of importance:

Helps in measuring efficiency: It shows how well a company is converting its sales into profit.

Useful for comparisons: It allows comparison of performance over different years. It can also be compared with other businesses in the same industry.

Helps in decision-making: Owners and managers can make better decisions about cost control and pricing.

Indicator of financial health: A higher operating profit ratio shows better cost management and profitability.

Limitations of Operating Profit Ratio

Even though the operating profit ratio is helpful, it has certain limitations. It cannot give a complete picture of the business alone. Below, we’ve mentioned some of the main limitations:

Ignores non-operating incomes: Incomes from outside operations are not included, which may sometimes hide the real profit.

Industry variations: The ratio may vary from industry to industry. Comparing different industries may not be useful.

Affected by accounting policies: Different companies may follow different accounting methods, which can change the calculation.

Does not show future performance: The ratio is based on past data and cannot guarantee future success.

Difference between Operating Profit Ratio and Operating Ratio

Many students get confused between the operating profit ratio and the operating ratio. While they may look similar, they are not the same. Below, we’ve mentioned the difference between the operating profit ratio and the operating ratio:

The operating profit ratio is an important tool to judge the operational strength of a business. It tells us how much profit is made from normal business activities in relation to net sales. With the help of its formula, components, and step-by-step calculation, it becomes easy to use this ratio.

While it has many advantages, like measuring efficiency and supporting decision-making, it also has certain limits. Therefore, it should be used along with other ratios for a complete analysis. For commerce students, the operating profit ratio is not only a part of the syllabus but also a key concept to understand business performance.