What is operating ratio?

Just what is operating ratio?

Operating ratio (OR) is a way for investors to compare the financials of one company against its peers. Investors use OR to gauge whether a company is generating sufficient profits. 

The formula to calculate OR is to divide a company’s operating expenses by its revenue. Put differently, it is one minus the operating margin percentage. For example, a 20% operating margin is the equivalent of an 80% operating ratio. Operating expenses include items such as fuel, maintenance, and crew or employee costs, as well as toll expenses or maintenance-of-way costs. They also include equipment rentals.

“OR is a measure of efficiency. The lowest-cost provider with the lowest amount of operating expense wins the game,” said railroad economist Jim Blaze. 

In this day and age, investors looking at the Class I railroads generally view an OR in the mid-50s as being a financial target for railroads to hit, although OR can generally range from 55% to 65%. The rail industry’s operating ratios have come down steadily over the years and are currently the best they have ever been. The Class I railroads are known for having a “good” OR because their relatively wide margins enable them to invest sufficient capital in their networks while also having positive cash flow left over to not only cover their debt and their dividend but to also repurchase large quantities of shares and raise the dividend over time. It might also mean they can pursue growth-oriented investments. 

The trucking industry typically has a much higher OR, with large public carriers in the 90s and smaller, less sophisticated carriers close to 100 or even above 100. An outstanding OR for trucking would be in the 80s. An operating ratio above 100 means that the company’s revenue is not sufficient to cover its operating expenses, much less have profit left over for debt service or to return to shareholders. The trucking industry is a much more fragmented and competitive marketplace than the railroad industry; the associated lack of pricing power is the crux of why the operating ratios in the truck industry are typically higher than in the rail industry. In addition, the railroad industry is more capital-intensive (capital expenditures as a percentage of revenue) than trucking so wider margins are necessary to justify the major capital investments.