Return on Sales
One of the main reasons for running a business is to make profits.
If your business is already generating revenue, you would want to know if it’s making enough to keep itself running.
A business needs cash in order for it to operate continuously after all, and having a steady source of cash is always welcome.
You wouldn’t want to only rely on external funding just to keep the business running as that can become costly.
Instead, you should want that steady source of cash to come from your operations.
A business can appear to be generating high revenue and sales numbers, and at the same time be slowly eating away its resources.
This will eventually lead to the decline of the business, or even its closure.
For example, a business had revenue of $500,000, but its operating income is only $30,000, and that’s not even considering non-operating expenses and taxes.
If the same pattern keeps on happening for several periods, the business will eventually exhaust its resources and go bankrupt.
That’s why it’s important to keep track of your business’ Return on Sales (ROS).
What is Return on Sales (ROS)?
ROS, also known as the operating margin, is a financial ratio that measures how much operating profit is made from the sale of goods or services.
For example, if a business’s ROS is 0.35 or 35%, then it means that for $1 of sale, the business has an operating profit of $0.35.
The ROS is a step further than the gross margin as it considers operating expenses on top of the cost of goods sold.
By measuring how much operating profit the business is making from its revenue, ROS gives us an idea of whether or not the business’s management is doing a great job of making the most out of its resources (assets).
If they’re efficient, then it’s more likely that the business’s ROS would be high.
If they’re not, then the ROS would be low.
It’s good practice to compare your business’s current ROS to previous periods’ ROS.
Doing so will let you know if it has gone up or down, and can help you in deciding whether certain operating policies should be kept as is, or be modified.
If ROS is growing, then that means the business is growing too in terms of operational efficiency.
If it is going down, then that probably means that your business is also declining.
As a business owner, you would want your business’s ROS to be on steady growth, or at the very least, not declining for consecutive periods.
The acceptable level of ROS for a business would depend on the industry that it belongs to.
Some industries are expected to have higher operating costs than other industries, which would for these industries to have lower ROS.
It’s important to remember that when comparing your business’s ROS to another business’s, make sure that they’re within the same industry.
How to compute Return on Sale?
Computing a business’s ROS may sound intimidating because of how it is a financial ratio.
But in truth, it’s simple to calculate.
You only need two figures: the figure for operating income, and the figure for revenue (or net sales).
Sometimes, EBIT is used in place of operating income.
ROS can be computed using the formula:
ROS = Operating Income ÷ Revenue (or Net Sales)
ROS= EBIT ÷ Revenue (or Net Sales)
*EBIT means earnings before interest and taxes
Do note though that when using EBIT as your numerator, make sure to exclude non-operating income/expense items if your business has them.
Add back non-operating expenses, and deduct non-operating income.
This is because the purpose of computing ROS is to know the operational efficiency of the business.
For the denominator, we either use revenue or net sales depending on whether the business has sales discounts, returns, and allowances.
For those that don’t, we will be using the revenue figure.
For those that do, we need to deduct the said items from the gross sales/revenue to come up with the figure for Net Sales.
Put into formula form, it would look like this:
Net Sales = Gross Sales – Sales Discounts – Sales Returns – Sales Allowances
Let’s have a quick exercise so that we can get familiar with the formula:
Company JK has the following data from their 2020 income statement:
To compute for ROS, we must first compute for the Net Sales:
Net Sales = Sales – Sales Discounts – Sales Returns – Sales Allowances
Net Sales = $550,000 – $27,500 – $8,250 – $15,125
Net Sales = $ 499,125
Company JK’s has a net sales of $499,125 for 2020. Now we can compute for its ROS:
Return on Sales = Operating Income ÷ Net Sales
Return on Sales = $89,815 ÷ $499,125
Return on Sales = 0.18 or 18%
As per our computation, company JK has a ROS of 0.18 or 18% for 2020. This means that for every $1 of sale made, it has an operating income of $0.18.
That wasn’t complicated, right?
Let’s try it again with Intel Corporation’s income statements for the years 2020, 2019, and 2018:
Let’s start first with the ROS for 2018:
Return on Sales = Operating Income ÷ Net Revenue
Return on Sales = $23,616,000,000 ÷ $70,848,000,000
Return on Sale = 0.33 or 33%
Intel Corporation’s ROS for 2018 is 0.33 or 33%.
Return on Sales = Operating Income ÷ Net Revenue
Return on Sales = $22,035,000,000 ÷ $71,965,000,000
Return on Sales = 0.31 or 31%
Intel Corporation’s ROS for 2019 is 0.31 or 31%.
Return on Sales = Operating Income ÷ Net Revenue
Return on Sales = $23,678,000,000 ÷ $77,867,000,000
Return on Sales = 0.30 or 30%
Intel Corporation’s ROS for 2020 is 0.30 or 30%.
Put side by side, Intel Corporation’s ROS for the years 2018, 2019, & 2020 are:
|Return of Sales||33%||31%||30%|
Noticeably, Intel Corporation’s ROS has been declining from 2018 to 2020, although they still had a respectable ROS of 30% in 2020.
The decline can be caused by a lot of factors such as a decline in revenue, an increase in costs and expenses, or maybe both.
Intel Corporation’s case, it is the increase in costs that had a major part of the decline in ROS basing on its income statements.
Uses of Return on Sales:
The ROS is a great tool for the business’s internal parties such as the owner/s, investors, management, and employees.
The owner/s and investors can use it to assess whether their investments are being utilized well by the business’s management and employees.
They can also use it to see if the business is growing in terms of operations.
As for management and employees, they can use it to assess if they are hitting certain targets or not.
They can also use it to know whether whatever they’re doing is working for the betterment of the business or not.
Then from there, can decide whether some operational policies should stay as is or should be modified.
ROS is not limited to internal purposes though. It can also be used by external parties such as creditors, potential investors, and analysts.
Since ROS is one of the profitability ratios, they can use it to assess whether the business is profitable or not, particularly its core operations.
A business with a high ROS is more attractive for investors and creditors compared to a business with a low ROS.
However, a business with a low ROS can also be attractive if it has been steadily growing for several periods as it signifies potential.
The ROS, along with other financial ratios can help creditors decide whether they can lend your business money or not, and investors whether they’d think the business is a worthy investment.
For creditors, a high ROS would mean that the business has high profits which can be utilized for paying debts and finance costs.
For investors, a high ROS could potentially mean a high return on their investment.
Analysts can use the ROS to assess a business’s financial health.
As it is expressed as a decimal or percentage, they can then use it to compare it with other businesses within the industry no matter the size.
They can also use it to make forecasts and predictions as to the direction the business is going in terms of its operations.
Limitations of ROS
ROS on its own is limited on what it can inform you.
That’s why it’s best used in conjunction with other financial ratios, or even with previous period ROS.
Just looking at a single period ROS won’t tell you about its growth or decline.
Comparing ROS from several periods (preferably consecutive periods) will do the trick.
Also already mentioned, if you compare your business’s ROS with another business’s, make sure that the business you’re comparing with is within the same industry.
This is because different industries can have different acceptable levels of ROS.
For example, if you compare a business from the restaurant industry to a business that sells cars, then there would be a difference as they are from very different industries.
ROS vs Gross Margin
Gross margin (also referred to as gross profit ratio or gross margin ratio) is a financial ratio that measures how much profit a business is earning from its revenues after deducting the cost of making such revenue (cost of sales, cost of goods, and/or cost of services).
For example, if a business has a gross margin of 0.57 or 57%, that means that for every $1.00 of revenue, the business is earning $0.35 of profit.
Both ROS and gross margin measure the profitability and efficiency of a business’s operations.
However, ROS is a step ahead of the gross margin as it considers the operating expense on top of the cost of sales, as opposed to the gross margin which only considers the cost of sales.
The gross margin is particularly helpful if you want to know if the products or services your business offers are profitable or not, even more so if you’re offering several products or services.
If you want to know the efficiency of your business’s operations though, ROS would be more helpful as it also includes the operating expense in its computation.
ROS vs Net Profit Margin
The net profit margin (also known as profit margin or net margin) is a financial ratio that measures how much net income a business is earning from its revenue.
It is expressed as a decimal or percentage.
For example, if a business’s net profit margin is 0.18 or 18%, then that means that it is earning $0.18 net income for every $1.00 of revenue.
Net income is a business’s earnings after deducting all expenses (operating and non-operating) from all earnings (revenue and non-operating income).
It is the amount that will go to a business’s retained earnings after deducting dividend payments.
Both ROS and net profit margin measure the profitability of a business, though ROS’s scope is only operations, while the net profit margin covers all financial aspects of the business (operating, financing, and investing activities).
Just like how ROS is a step ahead of the gross margin, the net profit margin is a step ahead of ROS as it considers a business’s non-operating activities on top of operating activities.
Net profit margin includes non-operating income and expenses (including interest expense) and income tax in addition to operating income in its computation.
ROS is helpful if you want to assess the efficiency of a business’s core operations.
As it only includes income and expense items that relate to operating activities, then you won’t have to worry about the inclusion of non-operating income and/or expenses.
Net income on the other hand is more helpful if you want to assess a business’s profitability as a whole.
A business can have great operating income but have negative net income due to poor handling of financing and investing activities.
The net profit margin captures that while the ROS does not.
FundsNet requires Contributors, Writers and Authors to use Primary Sources to source and cite their work. These Sources include White Papers, Government Information & Data, Original Reporting and Interviews from Industry Experts. Reputable Publishers are also sourced and cited where appropriate. Learn more about the standards we follow in producing Accurate, Unbiased and Researched Content in our editorial policy.