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When running a company, one of your most important tasks involves making sure your business is financially healthy and stable. In order to evaluate your business’ financial health, you will use a variety of tools, including various financial ratios based on the company’s most recent data. One of the ratios you can calculate to assess your business’ financial situation is Return on Sales.
What is Return on Sales?
What Is Return on Sales Used for?
Return on Sales is an important component of a company’s evaluation. It may be used for a wide variety of purposes, from internal assessment to assessments conducted by creditors or investors.
When this ratio is calculated internally, Return on Sales is typically used to determine whether the company is operating as efficiently as it can on its current investments. A poor Return on Sales may encourage decision makers to modify certain aspects of the company’s operations in order to reduce overhead costs, while a good Return on Sales ratio will encourage decision makers to leave things as they are or simply tweak a few things to improve this ratio even more. Companies may also calculate this ratio internally to evaluate growth over time.
When calculated externally, Return on Sales is usually used to evaluate the health of a company. For example, creditors may use Return on Sales as part of their decision-making process when processing a credit application. A poor Return on Sales ratio may cause a creditor to determine that the company isn’t a good risk, while a good Return on Sales ratio is reassuring and raises the chances of the application being approved. Likewise, potential investors may use the company’s Return on Sales ratio to decide whether it will be a good investment. Current investors may also use Return on Sales ratios to evaluate how well their investment is performing.
How Do You Calculate Return on Sales?
Calculating your company’s Return on Sales ratio isn’t complicated. To calculate this ratio for a specific period, simply divide the company’s operating profit for the period by the company’s net profit for the same time period. Multiplying the result by 100 will convert the ratio to a percentage. Either form of the Return on Sales ratio can be used to evaluate the company’s operational efficiency.
Return on Sales (ROS) = Operating Profit (OP)/Net Sales (NS)
To find your company’s Operating Profit, you must begin by taking inventory of all of your operating expenses, which may include:
- Inventory costs
- Marketing expenses
- Equipment purchases and rentals
Make sure that you do not include any non-operating expenses, such as interest or income tax, in this inventory.
Next, subtract your operating expenses from Net Sales. The result is the company’s Operating Profit.
Net Sales can usually be found listed on your company’s income statement. However, you can also calculate net sales on your own by:
- Adding together all sales transactions for the period to find total sales.
- Subtracting all sales returns, sales discounts and allowances for the period from the total sales.
Assume you want to calculate your company’s Return on Sales ratio for the year 2020. You have the following information about your company’s finances during the year:
- Total sales: $300,000
- Salaries and Wages: $40,000
- Rent expenses: $15,000
- Interest expenses: $3,000
- Income taxes: $2,000
- Depreciation expenses: $5,000
- Sales discounts: $4,000
- Sales returns: $5,000
- Allowances: $1,000
First, you must find Net Sales by subtracting allowances ($1,000), sales returns ($5,000) and sales discounts ($4,000) from total sales ($300,000).
Net Sales = $300,000 – ($5,000 + $4,000 + $1,000) = $290,000
Next, you must total your operating expenses so you can find Operating Profit. Operating expenses in this case include salaries and wages, rental expenses and depreciation expenses. Interest expenses and income taxes are not included. Thus,
Operating expenses = $40,000 + $15,000 + $5,000 = $60,000
To find Operating Profit, subtract operating expenses ($60,000) from Net Sales ($290,000).
Operating Profit = $290,000 – $60,000 = $230,000
Now you have everything you need to calculate Return on Sales:
Return on Sales = Operating Profit/ Net Sales
Return on Sales = $230,000/$290,000 = 0.7931
This can also be expressed as 79.31 percent.
For 2020, your Return on Sales ratio was 0.7931 or 79.31 percent.
What Is a Good Return on Sales Ratio?
Now that you know how to calculate your Return on Sales ratio, you may wonder what number is considered ideal. In the example above, the resulting ratio was much higher than most companies’ actual numbers would be. In fact, if your business is established and has a low risk level, having a Return on Sales ratio of only 5 percent may be acceptable. In businesses with higher risk levels, higher Return on Sales numbers are often necessary to indicate good financial health. For example, if you own a high-risk business, you may aim for a Return on Sales ratio of 20 percent or even higher than that.
Every company is different. To determine your company’s ideal Return on Sales ratio, you need to consider:
- Your company’s niche
- The competition
- Risk levels
- Investor or creditor preferences
Tips for Interpreting Your Return on Sales Ratio
As discussed above, every company is unique. What is considered a good Return on Sales ratio for one company may be a poor Return on Sales ratio for another, depending on each company’s characteristics. To interpret and utilize your company’s Return on Sales ratio as effectively as possible, follow these tips.
1. Be clear on the meaning of your Return on Sales ratio.
To use your Return on Sales ratio property, you need to understand its meaning. Essentially, this ratio is telling you whether the money you are investing in business operations is bringing a profit. If you are making a profit, the ratio will also indicate how high your profit margins are by telling you what percentages of your operating expenses are being converted to profit.
2. Remember that your business’ goals are unique.
Don’t get caught up in comparing your company’s Return on Sales ratio to every other business’ numbers. Although comparing Return on Sales ratios can sometimes be useful, comparisons should only be used in situations where businesses are working within the same parameters.
3. Watching your Return on Sales ratio over time can be beneficial.
As your company grows and changes, its Return on Sales ratio may change too. Watching this ratio over time can give you an idea of how your company is progressing. If you notice that the Return on Sales ratio is dropping, for example, it may be time to make some changes to the way the company operates. On the other hand, if the Return on Sales ratio increases or remains constant, you will be reassured of your company’s financial health and stability.
4. Compare Return on Sales ratios when appropriate.
Although you should not compare your Return on Sales ratios to every company around, it is useful to compare these ratios in certain situations. Only compare your Return on Sales ratio to that of another company if the company is in the same industry as yours. Some industries have naturally higher or lower profit margins, which impacts this ratio significantly.
It is also a good idea to stick with companies that are similar in age. A company that has been established for decades
A Note About Return on Sales Ratios vs Operating Profit Margin
How to Improve Return on Sales Ratios
Key Takeaways about Return on Sales Ratios
When you are looking at all the different numbers that can be used to evaluate the health of your business, it can be overwhelming and confusing. Here are some of the most important things to remember about Return on Sales ratio as you move forward.
- Return on Sales ratio indicates operational efficiency. – Your company’s Return on Sales ratio gives you the percentage of operational investments that are converted to profit.
- Higher is better. – The higher your company’s Return on Sales ratio, the more efficiently it is performing.
- Return on Sales ratio can be used externally. – In addition to calculating this ratio on your own to evaluate the health of your company, it may also be used by external sources. For example, potential investors and creditors often use this ratio to assess the financial health and/or risk level of your company.
- The calculation of Return on Sales ratio is straightforward. – To calculate your company’s Return on Sales ratio, you will simply divide the operating profit by net sales. You can convert this ratio to a percentage by multiplying by 100.
- Comparisons should be used with caution. – Although you can gain some valuable information by comparing your company’s Return on Sales ratio with others, this strategy should be used carefully and sparingly. Only compare Return on Sales ratios with other companies in the same industry, and remember that an established company has an advantage over a new company.
- You can improve your Return on Sales ratio. – If your current Return on Sales ratio is disappointing, there are ways to improve it. By making your current investments more profitable, or by reducing your operating expenses, you can boost the Return on Sales ratio. However, keep in mind that a reduction in operating expenses may reduce profits, so proceed with caution and make careful decisions.