Corporate Finance For Dummies
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The following ratios are of primary concern for those people who manage, own, or lend to companies that have large capital investments — companies that need things that are very expensive to operate. These companies could be part of the manufacturing industry, which usually requires machines of some sort, the transportation industry, such as airlines or buses, or utilities, such as electrical or water.

These types of organizations tend to have an extremely high proportion of their assets held in extremely expensive pieces of capital that are directly related to their operations, called operating assets. For example, a jet plane would be an operating asset for an airline.

The big thing that these industries, as well as many others, have in common is that they’re heavily dependent on operating property and long-term debt. However, even though the metrics here deal first and foremost with these industries, you can apply every single one of them to just about any organization to provide a measure of the organization’s asset management.

If you’re analyzing a company with lower levels of operating assets or long-term debt, don’t forget to take that into consideration and use the ratios in context with other metrics and other information.

Operating ratio

The operating ratio measures the financial effectiveness of a company’s core operations. You can use the following equation to calculate this ratio:


Follow these steps to make sense of this equation:

  1. Find the operating expenses and revenues on the income statement.

  2. Divide the operating expenses by the operating revenues to determine the operating ratio.

The answer is a measure of the ratio of assets that are taken up by expenses, all related to the company’s core operations.

For example, if the company is an airline, then the operating revenues would be those revenues generated from ticket sales and in-flight purchases, while the operating expenses would be the cost of the planes, the cost of fuel, the wages for pilots, and everything else related directly to the transportation service.

Percent earned on operating property

After a company has its operating property (all the large machines or plants or vehicles it needs to do its business), it likes to determine whether this operating property has been capable of generating earnings. You measure the ability of a company’s operating property to create income by using the percent earned on operating property:


Here’s how to put this equation to use:

  1. Find the net income on the income statement and the operating property on the balance sheet.

  2. Divide the net income by the operating property.

  3. To turn that number from a ratio to a percentage, multiply it by 100.

The answer is the percentage of operating assets that has generated income. For many companies, this ratio is sort of like the ultimate measure of whether they’re effectively investing in their primary operations.

A low ratio may indicate that the company isn’t investing enough, is investing too much, or is simply investing in the wrong assets. A high ratio may indicate that the company is generating a high level of income by using the assets it has available.

Determining which ratios are high and which ones are low depends greatly on the specific industry, so for the percent earned on operating property to be useful, companies have to compare both the competition and current trends.

Operating revenue to operating property ratio

Whether a company is able to actually make any money by using its operating property is something that managers, investors, lenders, and pretty much everyone else want to know. Because companies use operating property to generate operating revenues, they calculate the operating revenue to operating property ratio like this:


Work through these steps to use this equation:

  1. Find the operating revenue on the income statement and the operating property in the assets portion of the balance sheet.

  2. Divide the operating revenue by the operating property.

Having an asset that doesn’t do anything to generate earnings is a waste of money. Particularly for companies that have large purchases with long-term usage, determining whether or not those large purchases are generating enough revenues to make them worth the interest expense is a pretty big deal.

The appropriate value of this ratio depends a lot on the specific industry the company works in, so for the ratio to be useful, companies have to compare their ratio to those of their competitors as well as watch for annual trends.

The operating revenue to operating property ratio should always be higher than the percent earned on operating property (see the preceding section). If the percent earned on operating property is very much lower than the operating revenue to operating property ratio, the company may be experiencing ineffective asset management in nonoperating assets or other operational efficiencies.

Long-term debt to operating property ratio

For companies that work in transportation or other industries that require a large degree of capital investment, long-term debt is a critical concern. To determine the degree of property that a company funds by using long-term debt, analysts use the long-term debt to operating property ratio:


Follow these steps to use this equation:

  1. Find the long-term debt in the liabilities portion of the balance sheet and the operating property in the assets portion of the balance sheet.

  2. Divide the long-term debt by the operating property to calculate the ratio of long-term debt to operating property.

The appropriate level for this ratio depends greatly on the potential growth of the company. When a company makes purchases of large equipment, such as buses, planes, or machines, the company increases the total capacity of its business.

But because these are such large purchases, all but the largest companies likely have to get loans to make them. So you can expect a high ratio for companies that are new or have even a moderate growth rate.

About This Article

This article is from the book:

About the book author:

Kenneth W. Boyd has 30 years of experience in accounting and financial services. He is a four-time Dummies book author, a blogger, and a video host on accounting and finance topics.

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