Return on sales measures the operating profit margin of the company and how the management is working on using the resources. It evaluates whether the management is efficiently using the resources or not to generate the revenue. And thus provides an insight into the company’s operations to the creditors and other prospective investors.
Every business has certain goals, and one of the primary ones is profit-making. Businesses require money to run. And thus, it is necessary for a business to make a profit to further invest in the business to make it a continuous process. To understand whether the revenue is getting converted into actual profit or not and how much percentage of the revenue is your actual profit after deducting all the expenses. Return on sales is the measure you need for calculating your profit percentage. Return on sales analysis will give you a clear idea of how much profit you are making from your revenue generation. And whether it is meeting your standardized profit margin or not.
What is Return on Sales?
In simple terms, return on sales or ROS is a financial ratio for measuring the profit percentage against the revenue a business generates. A business generates revenue, and there are expenses that are incurred to generate that revenue. ROS measures how much percentage of the revenue is actually converted into the company’s earnings. It shows the company’s efficiency in making a profit on the revenue generated.
It is also known as the operating profit margin as it gives an insight into the operation efficiency of the company. This means whether the company is operating at its optimal potential or not. The profit which is measured for the ROS is the operating profit generated from the top-line revenue of the company. Operating profit/ROS thus forms a major part of the company’s evaluation process. Not only for the internal purpose but majorly for the creditors and the investors who look for better profit margins.
Formula and Calculation
Return on Sales calculation is important for every business house, and the calculation is pretty simple. It is the company’s operating profit in a particular financial period, which is divided by the net sales of the same time period. The formula is as follows –
Return on sales (ROS) = Net income before interest and taxes / Net sales
You need to make sure that the equation doesn’t include any of the non-operating activities and gains or losses from them. For example, there are no taxes, financing costs, or dividends included in the calculation. These are not the operating expenses, which means these are not generated through the firm’s main business. For instance, if you have a business of constructing buildings but side by side, you also invest money in real estate shares; your operating profit will include the profit generated from constructing buildings and not from investments in the shares. Then you cannot show the interest on the loan you have taken for personal purposes and even for the business and the income taxes, corporate taxes you pay, etc. This ratio is the core profitability and efficiency ratio. And thus, the ROS calculation uses only the top-line revenues and the operating profits.
To understand the return on sales a little better, here are some of the numerical
‘A’ runs a restaurant where he generates yearly revenue of USD 1000000. The operating profit is USD 200000. Therefore the return on sales or ROS = 200000/1000000 = 20%
In this example, we can see that 20% of the revenue generated by Mr. A actually converts into the operating profit margin of the company. In other words, if we see it from the cost forefront, Mr. A uses 80% of the revenue to generate 20% profit and to run the business. If the standardized profit of Mr. A is more than 20%, then he needs to decrease his expenses and increase the revenue to increase the operating income on a net basis.
If Mr. X makes an operating profit of INR 2000000 and his yearly revenue is INR 1 crore, then his business has a ROS of 20%. While Mr. Y makes an operating profit of INR 200000 and his revenue for the time period is INR 500000, his operating profit or ROS is 40%. So, the amount of profit doesn’t determine the efficiency of the business. This is why Mr. Y is making more profit out of his revenue while Mr. X having 20 times more revenue, generates less profit percentage.
FULL RATIO ANALYSIS (32 RATIOS)
We have covered the complete ratio analysis – its significance, application, importance, and limitations, and all 32 RATIOS of ratio analysis that are structured and categorized into 6 important heads.
Read more: OPERATING MARGIN RATIO
Return on Sales with Revenue and Expenses of Businesses
To understand how ROS is calculated in a business firm, you need to play with the figures for sales, revenue, and income. Here is a small example –
Sales – INR 1000000
Expenses – INR 850000
Profit = INR 150000
Therefore; ROS = 150000/1000000 = 15%
It is important to make a ROS analysis to understand what insight it puts into a company’s financials. Since it is a ratio that measures the efficiency and profitability of a business. It shows how efficiently a company’s management uses the resources to generate revenue and earn a profit. It shows how well the products and the services are optimized and how the costs are reduced.
ROS is a measure of both the efficiency and profitability metrics, as profitability doesn’t always signify efficiency in a business. As we see in the second example, with less amount of profit generated by Mr. Y, the percentage of the profit is double what Mr. X generates, but the revenue of the latter is 20 times the former. Here, the efficiency card plays its role. Mr. Y generates 40% income with less revenue because he can keep the costs within 60% of the revenue generation while the operating costs of Mr. X shoot up to 80%.
Thus, one cannot judge profitability only by the numbers of profits, but he should measure the efficiency along with it to evaluate the company’s performance.
Uses of Return on Sales
The creditors and investors often use this ratio to understand how well the company is running. And if it is using its resources optimally or not. It is a metric for comparing the peers in the industry and comparing their own profit with the standardized profit of the firm or the industry. Usually, it is observed that the companies with 20% and above operating profit margins are more stable and efficient in managing their resources. At the same time, anything more than 15% is regarded as vulnerable and implicates the improper use of the resources.
Return on sales thus evaluates the profit of a company and the company’s efficiency in generating that profit. The ROS efficiency measurement is important for internal and external purposes. It is a simple yet useful metric whose calculation is easy, and any business can use it regardless of its size.