What Is Return On Sales?
Return on Sales is a financial ratio that shows how efficiently a company can generate operating profit from its revenue. It is used to measure the company’s performance by analyzing what percentage of the revenue eventually results in profit for the company rather than being spent towards paying the company’s operating cost.
Thus, it is possible to assess the company’s profitability by using this ratio. It can be used to make a comparison between peer companies and also with the performance of the overall industry or sector to understand the company’s performance. A higher value of this ratio is always preferable but comparison should be made between companies in the same industry or sector.
- Return on sales is a financial ratio that measures a company’s ability to turn revenue into profit. It shows overall success by analyzing income used for operating costs versus gain.
- This ratio is the operating profit margin, which indicates a company’s efficiency in its operations.
- Investors, creditors, and debt holders rely on an essential financial indicator to evaluate a company’s operational efficiency. In addition, this indicator accurately explains the operating profit percentage derived from the company’s total sales revenue.
Return On Sales Explained
The return on sales ratio is also known as the operating margin and it helps in measuring the profit earning capacity of the business by comparing the operating profit to the net sales. The operating profit is the income earned form the core operations of the business and the net sales is the revenue earned from the sale of all goods and services.
It can also provide insight into how much profit is being produced per dollar of sales. Return on sales (ROS) is also known as operating profit margin since it gives an idea of the company’s operational efficiency.
It implies whether or not the company’s operation is running at its optimal potential. As a result, the value varies between industries.
Consequently, this ratio forms a crucial part of the evaluation process of a company that is not only used for internal purposes but mainly for the creditors and the investors who explore for better profit margins. A high percentage of return on sales ratio indicates that the business is able to generate quite a significant amount of profit from the core operations, whereas a low value shows that the business is not able to do so.
The calculation of rate of return on sales is done by dividing the operating profit by the net sales for the period, and it is mathematically represented as Return on Sales = Operating profit / Net sales * 100%
It is to be ensured that the operating profit does not include any non-operating income or expenses such as income tax, interest expense, etc.
How To Calculate?
The following five simple steps can be used to calculate the calculate return on sales of a company:
- Firstly, collect operating expenses such as rent, equipment, inventory costs, marketing, etc., from the income statement.
- Next, collect net sales also from the income statement.
- Now, subtract the operating expenses from the net sales to find the company’s operating profit.
Operating profit = Net sales Operating expense.
- Now, divide the operating profit by the net sales to find the portion of each dollar the company keeps as profit.
- Finally, multiply the above result by 100% to calculate the return on sales ratio as a percentage.
Return on Sales = Operating profit / Net sales * 100%
Let us consider an example of how to calculate return on sales for a company called PQR Limited. PQR Limited is in the business of manufacturing customized roller skates for both professional and amateur skaters. At the end of the financial year 20XX, QPR Limited has earned $150,000 in total net sales along with the related expenses.
- Net sales: (+) $150,000
- Salaries: (-) $50,000
- Rent: (-) $20,000
- Interest expense: (-) $10,000
- Depreciation expense: (-) $25,000
- Taxes: (-) $4,000
- Net income: $41,000
Based on the given information, the operating profit of PQR Limited at the end of the financial year 20XX can be calculated as,
Operating profit = Net sales – Salaries – Rent – Depreciation expense
[Interest expense and Taxes not included as these are non-operating expenses]
The calculation of Return on Sales Formula can be done as,
Return on sales =Operating profit / Net sales * 100%
Therefore, the Return on Sales Ratio of the company for the year 20XX stood at 36.67
- Every business owner has some definite goals, and one of the chief goals is to make a profit. A business needs money to operate. Therefore, it is essential for the business to make an adequate profit to invest more money to make it a continuous process. ROS is used to understand whether the turnover is being converted to actual profit or not, and if it is making a profit, then how much percentage of the turnover is the actual profit after subtracting all the expenses.
- The rate of return on sales is an important financial ratioImportant Financial RatioFinancial ratios are indications of a company's financial performance. There are several forms of financial ratios that indicate the company's results, financial risks, and operational efficiency, such as the liquidity ratio, asset turnover ratio, operating profitability ratios, business risk ratios, financial risk ratio, stability ratios, and so on. because various stakeholders of a company, such as investors, creditors, and other debt holders, trust this efficiency ratio since it accurately conveys the percentage of operating profit a company makes on its total sales income. Consequently, it provides insight into potential earnings, reinvestmentReinvestmentReinvestment is the process of investing the returns received from investment in dividends, interests, or cash rewards to purchase additional shares and reinvesting the gains. Investors do not opt for cash benefits as they are reinvesting their profits in their portfolio. potential, and the company’s debt servicing ability. A higher return on sales ratio for a company means that it is performing better because it retains more money as profit. Further, an increasing ROS shows that the company is growing efficiently, while a decreasing trend in the ratio could indicate looming financial difficulties.
- ROS is employed to compare current period performance with that of the previous periods. It eventually lets a company carry out trend analyses that help compare the internal efficiency performance over time. It is also useful in comparing one company’s return on sales percentage with that of another competing company, regardless of the scale of operation. In this way, an analyst may find it feasible to compare and assess the performance of a small company vis-à-vis a large company such as a Fortune 500 company.
- The equation for return on sales should only be utilized to compare companies within the same industry as the ratio varies significantly across industries. For example, a grocery retail chain has a much lower margin than a technology company, and the same trend can be seen for ROS for these industries, and as such, they are not comparable.
Inspite of having a lot of benefits and uses, the method has some limitations too, as given below:
- Varies with industry – The formula cannot be used to compare companies across different industries because it changes depending on the type of industry.
- Non-operating income or expense ignored- The formula considers only the operating profit that is generated from the core business. It does not account for the income or expenses that come from other sources like interest etc. but have an impact on the profit.
- Does not consider the fixed cost – The equation for return on sales does not take into account the effect of fixed cost on the profit of the business. A high fixed cost will affect the profits even though the operating profit and net revenue is quite high.
- Short term – The formula looks into the profitability of the company on a short-term basis, not from a long-term point of view.
Thus, it is equally important to consider the limitations along with the benefits to get a proper picture of the financial condition of the business.
Return On Sales Vs Profit Margin
The above are two very useful ratios that are frequently used by the management and stakeholders to assess the financial condition of the business. Let us understand the difference between them.
- The former is calculated by dividing the operating profit by the sales figures but the profit margin is calculated by dividing the gross or net profit by the net sales of the company, expressed as a percentage.
- The former helps in understanding how much percentage of profit one dollar can generate whereas the latter expresses the percentage of profit that is left after paying all the expenses.
- The profit margin can be gross or not profit margin, which is not the case with return on sales.
- The former measures the efficiency level of the company in generating profits, whereas the latter is a general term that includes many types of calculations for measuring the profitability.
Thus the above explanation gives us a clear idea about the two types of financial metrics used by companies.
Frequently Asked Questions (FAQs)
It is generally considered a good return on sales if your company’s operating profitability is at least 5 to 20 percent of its net revenues, depending on the industry. However, remember that some industries have higher cost structures than others.
To calculate the rate of return on sales, one needs to divide your business’s operating profit by the net revenue from sales for a specific period.
Return on sales shows how efficiently a business performs concerning its investments. In comparison, ROS represents how efficiently a company performs concerning its sales revenue.
Analysts and investors use ROS to evaluate and compare a company’s profitability with industry peers. It helps identify companies with strong operational efficiency and effective cost-management strategies.
This article has been a guide to what is Return on Sales. We explain its formula and how to calculate it along with examples & differences with profit margin. You may also have a look at the following financial analysis articles –