Return on sales, frequently known as the operating benefit margin, is a financial ratio which computes how effectively a business is at creating benefits out of its earnings. To put it differently, it steps a firm’s operation by assessing what percent of overall company earnings are in fact converted into business benefits.
Investors and lenders want to know more about this efficacy ratio for the reason that it reveals the proportion of cash that the business actually makes on its own earnings during a time. They could use this calculation to evaluate business performance from 1 period to another or compare two different sized firms performance for a given period.
These attributes make this equation extremely useful for investors because they can analyze the current performance trends of a business as well as compare them with other companies in the industry no matter the size. In other words, a Fortune 500 company could be compared with a regional firm to see which is able to operate more efficiently and turn revenue dollars into benefit dollars without regard to non-operating activities.
Let’s take a look at how to calculate the return on sales ratio.
The return on sales formula is calculated by dividing the operating benefit by the net sales for the period.
Keep in mind that the equation does not take into account non-operating activities like taxes and financing structure. For example, income tax expense and interest expense are not included in the equation because they are not considered operating expenses. This lets investors and creditors understand the core operations of the business and focus on whether the main operations are profitable or not.
Since the return on sales equation measures the percentage of sales that are converted to income, it shows how well the company is producing its core products or services and how well the management teams is running it.
You can think of ROS as both an efficiency and profitability ratio because it is an indicator of both metrics. It measures how efficiently a company uses its resources to convert sales into benefits. For instance, a company that generates $1,000,000 in net sales and requires $900,000 of resources to do so is not nearly as efficient as a company that can generate the similarly about of revenues by only using $500,000 of operating expenses. The more efficient management is a cutting expenses, the higher the ratio.
It also measures the profitability of a company’s operating. As revenues and efficiency increases, so do benefits. Investors tend to use this iteration of the formula to calculate growth projects and forecasts. For example, based on a certain percentage, investors could calculate the potentialprofitsif revenues doubled or tripled.
Let’s take a look at an example.
Assume Jim’s Bowling Alley generates $500,000 of business each year and shows operating benefit of $100,000 before any taxes or interest expenses are accounted for. Jim would calculate his ROS ratio like this:
As we can see, Jim converts 20 percent of his sales into benefits. In other words, Jim spends 80 percent of the money he collects from customers to run the business. If Jim wants to boost his net operating income, he can either focus on reducing expenses or increasing revenues.
If Jim can reduce these expenses while maintaining his revenues, his company will be more efficient and as a result will be more profitable. Sometimes, however, it isn’t potential to decrease costs greater than a certain sum. In cases like this, Jim should try for greater sales numbers while retaining the expenses the similarly. Both these approaches will make Jim’s Bowling Alley more effective.