A profitable company must make more money than it spends. The equation is fairly simple: profit or net income is defined as revenues minus costs. Analysts use a measure referred to as the working ratio in order to measure a company's ability to pay its operating costs with annual revenues. It is calculated by dividing total annual operating costs by annual gross income.
As a ratio, gross profit and operating costs combine to give the investor an indication of business health from an operational perspective. A working ratio lower than one indicates the company is able to recover operating costs. A working ratio higher than one is an indication that the company cannot pay its operating costs.
To understand more about the working ratio, it is important to understand its components. Total annual operating cost is a measure of total expenses, not including depreciation or debt related costs. Depreciation is a non-cash expense and debt-related costs are not directly related to the cost of maintaining operations. As such, these two expenses are subtracted from total operating costs.
Gross income is determined by subtracting the cost of goods, services and inventory sold from revenue. For instance, if annual revenues are $100,000 U.S. Dollars (USD) and the cost of goods sold is $60,000 USD, gross income is $40,000 USD. Many analysts look at gross income as an indication of the quality of a company's overall business model. Consequently, it is often used by investors interested in companies in the same industry or in the same line of business. If an investor wants to buy a company which sells baseballs, he or she can compare the gross profit margin of each company to see which company sells the baseballs at a lower operating cost.
One variation of the working ratio is working capital. It is calculated by subtracting current liabilities from current assets. Current assets are those assets which can be sold in one year or less. Current liabilities are those liabilities which must be paid in one year or less. This calculation is viewed as a measure of a company's operational efficiency.
Like the working ratio, working capital speaks to a company's ability to manage cash on a daily basis. That is, the calculation is commonly used as a way to measure a company's ability to manage cash flow. Examples of working capital are inventory, accounts receivable and accounts payable. The faster a company can convert these items to cash the better it is doing from a cash management perspective.