Starting or operating a business can be an exciting and rewarding adventure, it's best to have some guideposts to rely on so that owners can have the confidence to make smart decisions. The rent-to-revenue ratio is one of those guideposts. For many businesses rent is one of the larger fixed costs, this helpful aid provides a quick evaluation of how rent fits into the overall finances of the business.
WHAT IS THE RENT-TO-REVENUE RATIO?
It's a metric that helps organizations understand how much revenue goes towards rental costs in the form of a single percentage. To calculate the ratio (also known as occupancy cost ratio) you divide annual rent costs by annual sales (revenue). This will provide the percentage of revenue going towards rent costs.
Computing the ratio is fairly straightforward arithmetic, however understanding what the figure means is a slightly more nuanced exercise. Using the example above, a ratio of 14% means that the restaurant has 86% of the revenue to go towards all other expenses and profit. Depending on the business, the degree of importance of the ratio shifts. In businesses with higher margins/profits there is more room for high ratios or higher rent costs. Organizations with lower profit margins need to be more sensitive to rent costs, therefore the ratio becomes a more critical metric.
IDEAL RATIOS?
What is an ideal ratio for your business? Broadly speaking, ratios spanning all industries fall between 2-15% on average. High profit businesses such as law firms can be flexible with rent costs with ratios well into the 20’s. Lower margin companies should aim for ratios under 10. This allows the business to allocate most of its resources towards other aspects of operation. Keeping ratios as low as possible can help businesses weather sales/revenue volatility.
This is particularly important if a business is in a cyclical industry. If an organization's revenue stream is hyper sensitive to economic cycles or other factors that could impact revenue over longer periods of time, the focus should be on maintaining a lower ratio. Yet lower ratios shouldn’t always be a primary objective for all businesses. If a business is focused on high-end retail or requires a presence in or near a bustling market district then a higher ratio may be acceptable. The rent-to-revenue ratio is a useful tool to help organizations evaluate their financial position while also contributing to thoughtful decision making. We encourage organizations to use the ratio along with other business specific variables in determining the best path forward.