Return on Sales (ROS) indicates how much of the revenue is turned into profits, representing a company’s efficiency in its operations.
A rise in sales by 20% sounds impressive compared to an 8% increase in net income. However, it is necessary to understand how much profit the company manages to make from its total revenue.
This article covers what Return on Sales indicates, provides all the formulas for calculating and analyzing it.
Key Takeaways
- Return on Sales helps to see how much profit from sales is achieved but not whether the sales are growing.
- If margins increase, it might be because of reduced costs, but not in costs that secure future revenues. In such a case, the company starts to cut the areas that ensure growth.
- It is important to note that financing policy (access to credit) does not affect Return on Sales. Since ROS is calculated using data on operating profit, amounts and costs of loans do not impact the indicator.
- A sharp drop in the ROS for a single quarter, followed by a period of stability and growth, is less worrying than a long-term slow decline.
What is Return on Sales and How is it Calculated?
Return on Sales, also known as operating margin, indicates the portion of the company’s revenue that turns into operating profits after the costs connected with day-to-day operations are deducted. It is calculated as:
Return on Sales (%) = Operating Profit / Net Sales x 100%
Here,
- Operating profit is the profit of the company before interest and taxes, also referred to as EBIT.
- Net sales are total revenues with returns, discounts, and allowances deducted.
How is Return on Sales Different From Other Profitability Ratios?
|
Ratio |
What It Measures |
Key Difference from ROS |
|
Return on Sales (Operating Margin) |
Operating profit as a share of revenue |
Excludes interest and tax |
|
Net Profit Margin |
Net profit as a share of revenue |
Includes interest, tax, and one-off items |
|
Gross Margin |
Revenue minus cost of goods sold, as a share of revenue |
Ignores operating expenses like salaries and rent |
|
Return on Equity (ROE) |
Net profit as a share of shareholders' equity |
Measures return to shareholders, not operational efficiency |
|
Return on Assets (ROA) |
Net profit as a share of total assets |
Measures how efficiently assets generate profit |
Each of the indicators represents a different perspective on the profitability of a company.
By comparing Return on Sales with Gross Margin, you can see how successfully the company covers its costs associated with production.
Comparing to Return on Sales helps estimate the impact of interest and taxes on the profitability of the core operations.
Each of these ratios, viewed in isolation, cannot provide a complete understanding of the company’s performance, and therefore should be analyzed together.
Also Read About: Gross Profit
Importance of Return on Sales Ratio
Two companies can post identical revenue and still land in very different places on profitability, depending on how well each manages its costs. Thus, analyzing Return on Sales is essential to analyzing the profitability of any company. It might be particularly useful in the following situations:
- Comparing companies of different sizes within the same sector: A smaller company with a higher ROS than a larger rival is often being run more efficiently on a per-rupee basis, even if its absolute profit is smaller.
- Tracking a single company's trend over several years: A steadily improving ROS usually points to genuine operating leverage, meaning the company is getting more efficient as it scales.
- Assessing management quality during a downturn: How a company's ROS holds up during a weak revenue year often says more about the strength of its cost discipline than its performance during a boom.
Where Return on Sales Can Be Misleading?
It is important to remember that any ratio, by its nature, is limited and provides only a snapshot perspective. Return on Sales is not an exemption, and therefore some factors need to be taken with caution when interpreting this indicator:
- Intensity of capitalization is not considered: ROS is useful in comparing the efficiency of different companies without considering the amount of capital allocated to them. A company with a consistently high Return on Sales might be failing to yield value from the capital that it employs.
- Does not account for the nuances of depreciation and amortization policies: The accounting policy of a company might be chosen to favor the Return on Sales. In such cases, it is essential to investigate other sources, both official and third-party, when trying to obtain more information.
- Expenses of an exceptional character might be excluded from operating profit: Like the point above, some companies report an “adjusted operating profit” that provides a more favorable view of their performance. Such an “adjustment” should be viewed with skepticism since it might have been made to conceal weaknesses.
SEBI Regulatory and Disclosure Considerations on Return on Sales
Unlike other indicators, such as the P/E ratio, Return on Sales is not directly mandated by SEBI or the Companies Act. Investors must understand that the calculation of Return on Sales rests upon a few ratios that do have a mandatory status, and therefore the accuracy of this indicator is governed by the regulatory framework as well.
The Companies Act, 2013 provides in Schedule III that the company’s statement of profit and loss must specify all the items for calculating the profit, including operating expenses.
Ind AS 108, the standard on segment reporting, dictates that companies must report revenues and expenses of each segment separately when there is more than one.
SEBI, as the regulator of research analysts, provides in Research Analyst Regulations that the analysts who rate stocks must disclose the supporting evidence for their analysis.
As for indirect tax, no specific adjustments are required for the calculation of Return on Sales. It is important to note that the calculation of operating profit, the basis for Return on Sales, is also used to calculate taxable business income according to the Income Tax Act.
How to Check Return on Sales When Analyzing Company’s Performance?
- Look at the trend, not just the latest quarter: You can check ROS for the last 4 to 5 years and see whether it's improving, stable, or eroding. A single number in isolation tells you very little.
- Compare only within the same sector: Compare ROS only with direct competitors in the same sector, rather than the broad market average, because business models vary too much across different industries.
- Check what's driving a change: If ROS jumps, find out whether it is genuine cost efficiency, a one-off gain, or an accounting reclassification; each tells a very different story about the business.
- Read it alongside revenue growth: A high but shrinking-revenue ROS and a lower but growing-revenue ROS require very different judgment calls; neither is automatically the better outcome.
Conclusion
Return on Sales alone cannot tell you everything about a company's performance, but it is one of the more useful checks on operating efficiency of the businesses. It makes more sense when you look at it with other financial aspects such as Gross Margin, Net Profit Margin, and how much capital the company needs. So, when checking a company’s numbers, don’t look at Return on Sales alone, but look at it along with revenue, profit, and the other basic ratios.
