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What is a Return On Sales?
What’s important to know about it?
In this article, I will break down the meaning of Return On Sales so you know all there is to know about it!
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Table of Contents
What Is Return On Sales
Return on sales is a financial ratio used to calculate a company’s operational efficiency allowing you to calculate how much of its sales revenue translates into profits.
In other words, return on sales gives measures your “profit” for every dollar of sales.
For example, a company that generates $100,000 in sales and incurs $75,000 in operating costs will have an operating income of $25,000 which translates into a return on sales of 25% ($25,000 / $100,000).
The more a company’s return on sales is high, the more it has operational efficiency.
However, if a company’s return on sales is low, it should look for operational improvements to improve its ratio.
For investors and analysts, companies with very low return on sales should be assessed further for risk as the company is not functioning efficiently leading to financial troubles.
Keep reading as I will further break down the return on sales and tell you how it works.
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Why Is Return On Sales Important
Calculating return on sales is important for several reasons.
One key reason why companies, investors, and financial analysts will calculate return on sales is to assess the company’s operating efficiency.
The idea is to see how the company’s management is running its core business.
The return on sales tells you how efficiently the company is being operated and how profitable it is.
Another reason why return on sales is important is that it allows you to look at a company’s operating trend over a period of time.
By performing a trend analysis, a company is able to see whether it is improving efficiency or not.
This way, management can make the necessary changes or implement new processes to improve the company’s overall operational efficiency.
You can also use the return on sales to compare similar companies operating in the same industry.
This way, you can see how well one company is doing in relation to another.
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How To Calculate Return On Sales
To calculate return on sales, you can use the following formula:
Return on Sales = Operating Profit / Net Sales
A company can easily obtain these figures from its financial statements.
By looking at a company’s income statement, you can obtain the inputs you need to calculate return on sales.
First, you need to identify the operating profits which is the total sales less all costs and expenses to generate the sales.
Then, you need to find the company’s net sales.
To calculate net sales, you’ll need to take the company’s total revenues and deduct any refunds, credits, or discounts.
By dividing operating profits by net sales, you can see how many dollars of your net sales is translating into profits.
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Interpreting Return On Sales
Return on sales is an interesting financial ratio telling you about how a company’s managers are operating the business efficiently to produce profits.
Every company’s objective is to reduce costs and increase revenues through continuous improvement.
When companies calculate their return on sales, they can assess how much each dollar of net sales is translating into operating profits.
If the operating profits are low, the company should further investigate to understand the root cause.
If the operation is not running efficiently, investing in operational improvements will help reduce operating costs and lead to a higher return on sales.
If the company’s net sales are low, by investing in marketing, lead generation, and sales, the company can increase its sales.
The combination of reduced costs and increased sales will lead to a boost in return on sales.
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Return On Sales Limitations
Although return on sales provides useful insights into a company’s operational efficiency and profitability, there are certain limitations that you should be aware of.
One notable limitation is that you cannot easily compare companies operating in different industries.
Each industry will have a varying return on sales so what may be considered a good return on sales ratio in one industry may be bad in another.
You should use the return on sales to compare companies that operate in the same industry and have a similar business model.
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Return On Sales FAQ
What is a good return on sales ratio?
Just like many financial ratios, what is a good return on sales depends on the company’s circumstances and industry.
For example, if a company has a return on sales of 30% which appears to be quite good but similar companies in the same industry are at 60%, then you can see the company is may not be as efficient as its competitors.
On the other hand, if a company has a return on sales of 10% but the industry is at 5%, then this company has two times better.
Another way you can assess if your return on sales is good is to see if it’s growing over time or you are able to keep it steady where it should be.
Evidently, the higher the return on sales ratio, the better it is.
Many companies tend to aim for a return on sales of 5% to 10% but it remains a relative figure.
Difference between return on sales vs return on investment?
Return on sales represents the ratio between the company’s net sales and sales revenue.
This means that you are assessing how well your sales revenue is translating into profits.
On the other hand, return on investment is a profitability ratio allowing you to compare the company’s net income versus its overall investment.
This means that you are calculating how much a particular investment, at a particular cost, will return back.
Difference between return on sales vs operating profit?
What is the difference between return on sales and operating profit?
To start with, both return on sales and operating profit are financial ratios used to assess a company’s operational efficiency and profitability.
To calculate return on sales, you use net sales divided by operating profit.
However, to calculate operating profit, you take the operating income divided by net sales.
Difference between return on sales and return on equity?
Return on sales is a financial measure allowing you to see how efficiently a company is turning sales revenues into profits.
On the other hand, return on equity measures how efficiently a company is using its equity to generate a return.
You take the company’s net income and divided that by the shareholders’ equity.
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So there you have it folks!
What does return on sales mean?
In a nutshell, return on sales is a financial ratio measuring how efficient a company is running its operations.
A rising return on sales indicates that the company is generating profits and has the potential of reinvesting its profits back into the business to grow.
It also indicates that the company is running efficiently as it is turning more sales dollars into profits.
On the other hand, if the return on sales is diminishing, then a company may be headed towards financial troubles as its sales are not generating as much operational profits as it should be.
Return on sales is a ratio used along with other financial ratios to assess a company’s efficiency and overall profitability.
Now that you know what return on sales is and how it works, good luck with your research!
I hope you enjoyed this article on Return On Sales! Be sure to check out more articles on my blog. Enjoy!
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