Return on sales

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Return on sales
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Return on sales (ROS, called profit margin) - is a financial ratio used to derive the proportion of profits generated from sales. The return on sales indicates how effectively the firm is transforming sales into profits. Return on sales ratio is the ratio of net profit to net revenues from sales[1]. It measures how well costs are managed and also the profit generated on sales[2]

Important information to calculate return on sales

  • a measure of how efficiently a company turns sales into profits.
  • calculated by dividing operating profit by net sales.
  • only useful when comparing companies in the same line of business and of roughly the same size.

\(ROS=\frac{net\ income\ after\ taxes}{net\ sales}\)

Interpretation of ROS as compare details from last year[3]:

  • A higher level of ROS means a more favorable financial condition of the company.
  • A lower level of return of sales means that the company must realize larger sales volumes to achieve a certain amount of profit.

Observation of margin levels in the following months is important due to the possibility of predicting potential problems. Comparing the rates it is easy to see when sales are more profitable and determine its stability. Significant fluctuations are the starting point for the analysis of their causes - whether it was a change in profit or a change in sales volume. The main concern with this measurement is that it does not factor in the effects of financial leverage, such as a large interest expense obligation, and so tends to overstate the returns being generated by a business.

The main concern with this measurement is that it does not factor in the effects of financial leverage, such as a large interest expense obligation, and so tends to overstate the returns being generated by a business.

Purpose

ROS is used to compare current period calculations with calculations from previous periods. This allows a company to conduct trend analyses and compare internal efficiency performance over time. It is also useful to compare one company's ROS percentage with that of a competing company, regardless of scale.

Example

Company that generates US$120,000 in sales and requires US$100,000 in total costs to generate its revenue is less efficient than a company that generates US$60,000 in sales but only requires US$40,000 in total costs.

ROS is larger if a company's management successfully cuts costs while increasing revenue. Using the same example, the company with US$60,000 in sales and US$40,000 in costs has an operating profit of US$20,000 and a ROS of 33% (US$20,000 / US$60,000). If the company's management team wants to increase efficiency, it can focus on increasing sales while incrementally increasing expenses, or it can focus on decreasing expenses while maintaining or increasing revenue.

References

Footnotes

  1. Pride W., Hughes R., Kapoor J., (2010)
  2. Hugos M. H., (2010)
  3. Pride W., Hughes R., Kapoor J., (2010)

Author: Alicja Ficek