What is return on sales?

Return on sales is a metric that gauges the efficiency of a business’s operations. Expressed as a ratio, return on sales measures a company’s profit compared to operating costs or expenses in the context of overall revenue. In other words, return on sales measures how much profit is generated per dollar of revenue.

Businesses aim to have a higher return on sales ratio as it indicates greater operational efficiency. If the ratio is too low, it may suggest inefficiencies or weaknesses. The return on sales ratio is included on a company’s income statements, which internal or third parties can use to analyze the financial health of the business.

Read more: How to Read Financial Statements: A Manager’s Guide

Return on sales vs. profit margin

Return on sales is closely related to and sometimes used interchangeably with profit margin or efficiency ratio. There are various profit margins, one of which is return on sales. Another metric is net profit margin, which is the rate of return on net sales and a ratio that compares net profits and sales. Others include gross profit margin, which is often used to compare competing businesses, and operating profit margin, which describes the financial ratio with operating income.

Related: Financial Management: Basics for Business Managers

How to calculate return on sales

To calculate your company’s return on sales, acquire the necessary information and use this return on sales formula to express the ratio as a percentage:

Return on sales = (business operating profit / net sales revenue) x 100

When calculating return on sales, first obtain the business’ operating profit by subtracting costs or expenses from the revenue. Then, divide that amount by the net sales revenue.

As an example, consider a business with a quarterly operating profit of $600,000 and $400,000 in expenses. In this case, the company has $200,000 of business operating profit. The return on sales formula for the business looks like this:

Return on sales = (business operating profit ($200,000) / net sales revenue ($600,000)) x 100

Return on sales = 33%

This calculation results in a return on sales of 33%. This percentage represents the amount per dollar that your business generates in profit. In this case, the business’s return on sales is 33 cents per dollar of revenue.

Related: What Is Gross Revenue? A Definitive Guide for New Managers

The importance of return on sales

Return on sales is an important tool for analyzing a business’s operational efficiency, but it also has other uses.

Investors, creditors and lenders

Investors, creditors and lenders are interested in a business’s return on sales because it’s a straightforward profitability indicator. Profitability is important when stakeholders consider a business’s repayment ability, potential dividends, and reinvestment potential. Revenue alone isn’t enough information to tell potential investors or lenders if a business is a good investment or loan opportunity. Return on sales provides insight to stakeholders in terms of how efficiently a business generates profit with attention to both revenue and operating costs.

Internal use

Businesses can also use return on sales to improve their operational efficiency and increase profits. By analyzing how expenses and sales interact, businesses can glean better insight into opportunities for improvement. To improve efficiency and return on sales, businesses can consider options like:

• Sourcing or negotiating more cost-effective resources or services

• Increasing prices with attention to commodity markets

• Evaluating market trends for long-term planning

• Reorganizing staffing structures or operational costs to reduce overall expenses

• Comparing their return on sales to the performance of other similar businesses

Related: Understanding Fixed vs. Variable Expenses

Limitations of return on sales

While a business may sometimes compare its return on sales to another company’s to identify opportunities, this may not always be an effective strategy. Return on sales varies across industries, commodities and business models, so comparing businesses that aren’t relevant to each other may be confusing and ineffective. When comparing businesses’ return on sales, it’s important that the companies belong to the same industry and have similar business models and sales trends.

Return on sales doesn’t necessarily account for the full value of the business. While profit from sales is a useful indicator, it should be understood in conjunction with the other financial aspects of the business.

Related: Assets, Liabilities, Equity: An Intro to the Accounting Equation

Return on sales FAQS

What is a good return on sales?

Several factors must be considered when determining a good return on sales. An increasing return on sales year-over-year means that your business is becoming more profitable. Consider the overall industry and competitors as well. If the average return on sales for the industry is 15%, an ideal ratio is similar or higher.

What if a return on sales is negative?

If a return on sales is negative, this means the business has lost money during its operational process. In other words, a business with a negative return on sales is unprofitable and inefficient. This can happen if the business experiences reduced sales or higher operating expenses.

What’s the difference between return on sales and operating margin?

Both return on sales and operating margin are metrics used to describe a business’s financial ratio. These terms are often used interchangeably but are different. ROS uses earnings before interest and taxes (EBIT) in the numerator of the return on sales formula to account for adjustments, allowances, and any other nonoperating income. The operating margin, however, uses operating income divided by sales. Operating income accounts for operating expenses but doesn’t include taxes or nonrecurring revenue and expenses. The return on sales formula is based on Generally Accepted Accounting Principles, but the operating margin calculation isn’t.