What is return on sales

Return on sales is also referred to as net profit margin. However, it isn’t the same as gross profit. The gross profit calculation divides cost of goods sold by total sales. Gross profit margin measures your ability to sell a product for more than you produce it. For example, your direct labor and materials should be lower than the price you sell the product for.

Calculating Return on Sales

The factors for calculating return on sales are found on the income statement. First, you need net income, which is usually the bottom-line number. Net income shows how profitable your business was for a period of time. The other number you need is total revenue. Net sales track how much sales revenue your business earned for a period of time, net of any discounts or returns. This generates the following formula:

Return on Sales = Net Income / Net Sales

Since it’s not uncommon to have outlier expenses, many business owners and investors will back out certain expenses from the sales ratio. For one, you may choose to use operating profit instead of net income. Operating profit takes all normal operating expenses but excludes one-time items, like miscellaneous income. Operating profit will also exclude depreciation, interest, taxes, and amortization. Here is the formula if you choose to exclude certain items:

Return on Sales = Operating Profit / Net Sales

It’s important to note that the return on sales is meant to be a positive number. If your operating profit margin is actually a loss, you will generate a negative formula. It is highly unlikely that your business will have a negative sales figure. However, a negative operating income number is possible if your business has high levels of expenses compared to total sales.

Return on Sales Calculation Example

Let’s go through an example of a return on sales calculation. Let’s say that your total revenue is $1,000,000. Your operating expenses are $750,000, generating a gross margin of $250,000. You also have a one-time expense of $50,000, an interest expense of $25,000, and a miscellaneous income of $10,000. This generates an overall net earnings of $185,000.

Let’s first calculate return on sales with outlier expenses. Dividing $185,000 of net profit by $1,000,000 gives us a return on sales of 18.5%. This means for every $1 of sales, your business is keeping $0.185 of income as profit.

Now, let’s exclude the outlier expenses. Dividing our operating profit margin of $250,000 by total revenue of $1,000,000 results in a return on sales of 25%. Under this calculation, your company is keeping $0.25 of every $1 as profit. Both calculations yield different results, which is why it’s beneficial to implement both into your analysis.

Evaluating Return on Sales

Return on sales is used by investors, business owners, lenders, and other third parties to measure the efficiency of your operations. This calculation highlights the effectiveness of producing your core products or services. For example, if your return on sales calculation consistently shows a low number, it could mean you are overspending or need to find new revenue streams.

Return on sales should always be a positive number and the higher the calculation, the better your company is at producing profit. If your return on sales starts trending lower between periods, it could indicate you need to raise your prices or lower your expenses.

Investors and lenders might be hesitant to infuse capital into your company if your business doesn’t show a strong ability to repay debt. Let’s say you are only keeping $0.05 of every $1 earned. Your current net income is $50,000, and your total sales are $1,000,000. Your business is trying to secure a loan of $500,000 that comes with an average annual interest of $40,000.

Lenders will recalculate your return on sales based on your expected interest rate, creating a new return on sales of just $0.01. If your business has a one-time or outlier expense, you might not be able to pay your loan, which is a red flag for investors and lenders.

Furthermore, a return on sales that is drastically different between periods should be looked into. Let’s say your return on sales was 20% in one year and 10% in the next. There are a few possible explanations. For one, your business could have incurred a large one-time expense that is draining your profitability.

Another explanation is that your products or services are becoming outdated and you need to innovate. A lower return on sales might also indicate fraud. If you are concerned about the potential of fraud in your organization, be sure you are tracking expenses using the proper software, like Eftsure.

Limitations of Return on Sales

The comparability of return on sales to other companies is one of the main disadvantages of the calculation. Since every industry will have different profit margins and cash flow, companies can only be compared in the same industry. For example, a tech company would have widely different margins than a manufacturing company. The lack of comparability can impact your ability to gauge the results of your company with others.

One of the workarounds to the lack of comparability is to use a profitability ratio that uses EBITDA instead of net income. This would be the second formula in our calculations section. By adding back these items, you are able to remove major industry differences, such as a manufacturing company with significant depreciation expense.

Summary

• Return on sales measures the efficiency of your operations by dividing net income by net sales.
• The higher the return on sales calculation, the better. This means your business is able to convert more sales into profit.