Definition
The operating income to sales ratio is a performance measure that allows analysts to understand the results from operations before unrelated items are added or subtracted. Investor-analysts will track this ratio over time, so changes in profitability can be quickly identified.
Calculation
Operating Income to Sales Ratio = Operating Income / (Net Sales - Non-Operating Income)
Where:
Net Sales = Gross Sales - Returns
Non-Operating Income: includes items related to the company's financial activities.
Explanation
Operating performance measures allow the investor-analyst to understand how well a company is performing with respect to sales, margins, and profits. The operating income to sales ratio removes the effects of non-operating income activities, providing a clear picture of the company's ability to generate profits through its core business operations. Examples of non-operating activities include:
Gains and losses from investment activities
Sales of property or assets
Changes in currency exchange rates
Any other gain or loss that is not related to the core operating activities of the business
The operating income to sales ratio is particularly useful when a company's sales have been declining and the business may be selling off the company's assets or investments to increase net income. Ratios that decrease over time can indicate eroding margins.
Example
Company A's financial statements were indicating a small increase in earnings before income taxes (EBIT) over time. However, market analysts were concerned the company's margins were eroding due to a sharp decrease in their competitor's pricing strategy.
As the table below indicates, EBIT was slowly growing, but Company A also showed a steady increase in non-operating income. When the analyst examined Company A's operating income to sales ratio, they confirmed the portion of income derived from operations decreased from 25.8% in Year 0 to 21.6% in Year 3.
| Year 0 | Year 1 | Year 2 | Year 3 | |
| Sales Revenues | $25,000,000 | $26,250,000 | $27,563,000 | $28,941,000 |
| Operating Expenses | $18,750,000 | $20,063,000 | $21,467,000 | $22,970,000 |
| Operating Income | $6,250,000 | $6,187,000 | $6,096,000 | $5,971,000 |
| Non-Operating Income | $750,000 | $900,000 | $1,080,000 | $1,296,000 |
| EBIT | $7,000,000 | $7,087,000 | $7,176,000 | $7,267,000 |
| Operating Income to Sales | 25.8% | 24.4% | 23.0% | 21.6% |
