Return on sales
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.
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.
Advantages of Return on sales
Return on Sales (ROS) is a popular financial metric used to measure a company's profitability. It is a valuable tool for assessing a business's ability to convert its sales into profits, and can be a useful indicator of overall performance. Below are some of the advantages of using Return on Sales as a metric:
- It is a simple ratio to understand and calculate, as it requires only a company’s net sales and net income.
- ROS is a reliable measure of profitability, and provides a good indication of a company’s overall financial health.
- It is a useful tool for comparing the profitability of companies in different industries and of different sizes, as it takes into account the differences in sales revenue.
- It is a good metric for assessing the success of a company’s cost-cutting measures, as it measures the ability of the company to generate a profit from its sales revenue.
- It can also be used to measure the performance of a company over time, as it provides a measure of the company’s ability to generate profits despite changing market conditions.
Limitations of Return on sales
Return on sales (ROS) is a financial ratio used to derive the proportion of profits generated from sales. However, it has several limitations:
- ROS does not take into account the capital structure of the company and the effect of debt financing on the return on equity.
- It does not provide information on the cost of goods sold that could be used to assess how efficiently the company is producing its products.
- It does not consider other costs such as overhead, taxes, or marketing expenses, which can have a significant impact on profitability.
- It does not measure the quality of products or services, or customer loyalty.
- It does not account for factors outside of the company’s control, such as the economic environment or industry trends.
Return on sales is an important financial ratio used to measure a company's ability to generate profits from sales. Other approaches related to return on sales include:
- Return on Assets (ROA) - this is a measure of a company’s profitability, calculated by dividing net income by total assets.
- Return on Equity (ROE) - this is a measure of a company’s profitability when compared to investors’ equity. It is calculated by dividing net income by total shareholder equity.
- Operating Margin - this is a measure of a company’s operating performance. It is calculated by dividing operating income by total revenue.
- Gross Margin - this is a measure of a company’s profitability before accounting for operating costs. It is calculated by dividing gross profit by total revenue.
In summary, return on sales is a useful measure of a company's ability to generate profits from sales. Other approaches related to return on sales include ROA, ROE, operating margin, and gross margin.
| Return on sales — recommended articles |
| Combined Ratio — Berry Ratio — Return on net assets — Capitalization ratios — Basic earnings power — Market value added — Cost-income ratio — Coverage ratio — Cash Flow-to-Debt Ratio |
References
- Albrecht W., Stice J., Stice E., Swain M., (2007) Accounting: Concepts and Applications, Thomson Learning Inc, South-Western,
- Bragg S. M., (2007) Business Ratios and Formulas: A Comprehensive Guide, John Wiley $ Sons, Canada,
- Hugos M. H., (2010), Essentials of Supply Chain Management, John Wiley & Sons, USA,
- Pride W., Hughes R., Kapoor J., (2010), Business, Cengage Learning, South-Western
Footnotes
Author: Alicja Ficek
