What Is Return on Sales (ROS)?
Return on sales (ROS) is a ratio used to evaluate a company's operational efficiency. This measure provides insight into how much profit is being produced per dollar of sales. An increasing ROS indicates that a company is growing more efficiently, while a decreasing ROS could signal impending financial troubles. ROS is very closely related to a firm's operating profit margin.
Formula and Calculation of Return on Sales
Locate net sales and operating profit from a company's income statement and plug the figures into the formula below.
ROS = Net Sales / Operating Profit
ROS=Return on sales
Operating Profit is calculated as earnings before income and taxes, or EBIT.
When calculating return on sales, investors might notice that some companies report net sales while others report revenue. Net sales is total revenue minus the credits or refunds paid to customers for merchandise returns. Net sales will likely be listed for companies in the retail industry, while others will list revenue. Below are the steps to calculate return on sales.
- Locate net sales on the income statement, but it can also be listed as revenue.
- Locate operating profit on the income statement. Be sure not to include non-operating activities and expenses, such as taxes and interest expenses.
- Divide operating profit by net sales.
- Return on sales (ROS) is a measure of how efficiently a company turns sales into profits.
- ROS is calculated by dividing operating profit by net sales.
- ROS is only useful when comparing companies in the same line of business and of roughly the same size.
What Return on Sales Can Tell You
Return on sales is a financial ratio that calculates how efficiently a company is generating profits from its top-line revenue. It measures the performance of a company by analyzing the percentage of total revenue that is converted into operating profits.
The calculation shows how effectively a company is producing its core products and services and how its management runs the business. Therefore, ROS is used as an indicator of both efficiency and profitability. Investors, creditors, and other debt holders rely on this efficiency ratio because it accurately communicates the percentage of operating cash a company makes on its revenue and provides insight into potential dividends, reinvestment potential, and the company's ability to repay debt.
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.
The comparison makes it easier to assess the performance of a small company in relation to a Fortune 500 company. However, ROS should only be used to compare companies within the same industry as they vary greatly across industries. A grocery chain, for example, has lower margins and therefore a lower ROS compared to a technology company.
Example of How to Use Return on Sales
For example, a company that generates $100,000 in sales and requires $90,000 in total costs to generate its revenue is less efficient than a company that generates $50,000 in sales but only requires $30,000 in total costs.
ROS is larger if a company's management successfully cuts costs while increasing revenue. Using the same example, the company with $50,000 in sales and $30,000 in costs has an operating profit of $20,000 and a ROS of 40% ($20,000 / $50,000). 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.
The Difference Between ROS and Operating Margin
Return on sales and operating profit margin are often used to describe a similar financial ratio. The main difference between each usage lies in the way their respective formulas are derived.
The standard way of writing the formula for operating margin is operating income divided by net sales. Return on sales is extremely similar; only the numerator is usually written as earnings before interest and taxes (EBIT); the denominator is still net sales.
Limitations of Using Return on Sales
Return on sales should only be used to compare companies that operate in the same industry, and ideally among those that have similar business models and annual sales figures. Companies in different industries with wildly different business models have very different operating margins, so comparing them using EBIT in the numerator could be confusing.
To make it easier to compare sales efficiency between different companies and different industries, many analysts use a profitability ratio which eliminates the effects of financing, accounting, and tax policies: earnings before interest, taxes, depreciation and amortization (EBITDA). For example, by adding back depreciation, the operating margins of big manufacturing firms and heavy industrial companies are more comparable.
EBITDA is sometimes used as a proxy for operating cash flow, because it excludes non-cash expenses, such as depreciation. But EBITDA does not equal cash flow. That’s because it does not adjust for any increase in working capital or account for capital expenditures that are needed to support production and maintain a company’s asset base – as operating cash flow does.
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