Expense ratio
An expense ratio, often discussed in the context of mutual funds, is also a crucial metric for small businesses. It measures the total amount expressed as a percentage of a fund's or business' assets used for administrative and other operating expenses. Just as you'd want a car that gets more miles per gallon, a lower expense ratio means your business or fund is operating more efficiently, stretching each dollar further.
Understanding expense ratios
For small businesses, the expense ratio measures how efficiently the company is being run. A lower gross expense ratio often indicates that the business uses less of its revenue to cover operational costs, which can signify good financial health and management.
What does expense ratio mean?
When you see an average expense ratio such as 0.75%, it means that 0.75% of the company’s or fund’s assets or revenue is spent on operating expenses. In the context of mutual funds, this includes management fees, administrative fees, and other costs associated with running the fund. For a business, it reflects the portion of the fund's net assets or revenue used for operating expenses.
What is a good expense ratio?
A good expense ratio depends on the industry and nature of the business or fund. Generally, lower expense ratios are more favorable than higher expense ratios because they indicate that less money is spent on managing assets and more is returned to investors or retained within the business for growth. In mutual funds, expense ratios below 1% are often considered good, but the specific "good" level can vary depending on whether the fund is actively or passively managed.
How to calculate your expense ratio
Let's look at an example of how to calculate your business’ expense ratio. Suppose your business has total operating expenses of $75,000 and total revenue of $10,000,000 over the same period.
Here’s how you would calculate the expense ratio:
Expense ratio = ($75,000/$10,000,000) × 100 = 0.75%
This calculation tells you that 0.75% of your business' total revenue is used to cover operating expenses. An expense ratio of 0.75% is considered efficient, indicating that your business manages its operational costs effectively relative to its revenue.
FAQs about expense ratios
What does a 0.75 expense ratio mean?
A 0.75% expense ratio indicates that 0.75% of the fund's or business' assets are used each year to cover operating expenses, meaning for every $100 in assets, 75 cents are spent on operational costs.
What is the best expense ratio?
It's better to think of the "best" expense ratio as a reasonable expense ratio for your specific industry. A "good" operating expense ratio varies significantly by industry for many small businesses. Generally, the lower the fund's expense ratio is, the better, as it indicates more efficient resource use. A lower expense ratio means your business retains more revenue relative to its operational costs, which is crucial for sustainability and growth.
Is 1% a too high expense ratio?
For mutual funds, 1% is around the average for actively managed funds but is also considered high for passively managed index funds. For small businesses, whether 1% is high depends on the industry standards and the nature of the company.
How are expense ratios used in mutual funds and investing?
Expense ratios are important to consider when investing in mutual funds,as they directly reduce the fund's net returns to investors. A higher expense ratio can significantly impact a fund's total returns, especially over long-term investments. Investors often compare expense ratios when choosing between funds, as funds with lower expense ratios generally provide better net performance, assuming similar gross returns. In short, the lower the expense ration, the more money can be returned to investors.
How LegalZoom can help
LegalZoom provides resources and services that can assist small business owners in managing their financials more effectively. From setting up the correct business structure to minimize tax liabilities to offering tools for tracking and analyzing financial data, LegalZoom helps ensure your business maintains a competitive expense ratio. This support can be invaluable in optimizing your business operations and financial strategies.