How do you know your business is healthy? No need to call your fellow family practitioner! Look at your return on sales (ROS) ratio!
Similarly to health indicators helping doctors evaluate their patient’s physical state, this financial metric helps businesses analyze the health and efficiency of their operations. Expressed as a ratio, ROS can tell two important things about your overall revenue:
To put it short: ROS shows how much profit is generated per dollar of revenue.
In this article, we’ll break down the notion of ROS, its importance and inner workings, and explain how to calculate ROS to enhance your business with reliable financial data.
Return on sales (ROS) illustrates how much of your sales revenue is actual profit compared to your operating costs. In other words, it’s the number of sales that a company is capable of converting into profits.
No wonder why investors, business owners, and creditors are obsessed with ROS!
To calculate ROS, use the following formula: divide your company’s operating profit by your net revenue from sales for the reported period. Mind, please, that your operating profit should be calculated as earnings before interest or EBIT. Since ROS is typically presented as a percentage, the next thing you need to do is to multiply your results by 100.
And voila!
Let’s apply this formula to a hypothetical situation.
Imagine your company made $500,000 in sales and $400,000 in expenses in the past three months. To find out your ROS, subtract your expenses from your revenue. In this very case, your profit would account for $100,000.
Now divide your $100,000 profit by the total revenue of $500,000, and get a ROS of 0,2. This means that for every dollar of sales, your company makes 2 cents.
To get a ROS percentage, multiply 0,2 by 100. Your final ROS ratio is 20%.
For better visual perception, here’s your ROS calculation explained in great detail.
Bear in mind that this formula doesn’t cover non-operating activities like taxes. In the same way, interest and income taxes are not included in the equation because these aren’t seen as operating expenses. By excluding these numbers from the formula, investors and creditors better understand the business’s core operations and whether it is profitable.
ROS can tell how a company can use its resources to convert sales into profits. Say Company X generates $600,000 yearly with an operating profit of $200,000 before taxes or interest expenses. This is how they would calculate their ROS:
As one might conclude from the equation, Company X converts over 33% of its sales into profits and spends around 70% of the money collected from customers to keep the business running. If it wants to increase its net operating income, it should either cut expenses or increase revenue.
Ideally, Company X should lower operating expenses while maintaining the same revenue numbers to become more profitable. But sometimes, companies struggle to cut their expenses by more than a certain percentage. An obvious way out is to strive for higher revenue while keeping the same expenses.
Either of these strategies can help the company stay successful.
The overall concept of a good return on sales is relative per se as it depends on various factors, including your business’ size, industry, output volumes, and so on. However, it is generally believed that a good ROS fluctuates between 5-10%.
By having a grip on ROS, you can significantly improve your business, namely:
Since ROS is all about the company’s performance, there are other ratios that show different facets of it, such as return on investment (ROI) and return on equity (ROE). However, there is a slight difference between each of the terms. Let’s see what it’s all about.
While ROS determines how efficiently a business converts sales into profits, ROI measures the profitability of the company’s investments by comparing the net profits received at the exit to the initial cost of the investment.
The ROI formula is pretty plain as it requires simply dividing the net return on the investment. ROI is typically expressed in a percentage form, so the calculation result should be multiplied by 100.
Say, you invested $1,000 into your online store’s social media promotion. By the end of the holiday season, you’ve gained $5,000 from sales boosted through the ad promotion you’ve invested in. The ROI of your ad campaign would be as follows:
In other words, for every dollar invested into ads, you got $5 back.
ROE is another indicator of your company’s performance inferred from dividing your net annual income by shareholders’ equity. Multiply the result by 100 to get a percentage. The higher the ROE, the more efficiently your company is managed in terms of generating income and multiplying the equity of your shareholders.
While ROS is tied to the company’s profitability evaluated based on sales only, ROE is considered a gauge of a corporation’s profitability based on assessing its overall operations.
Imagine a company’s X net income in 2021 was $25 billion with a total stockholders’ equity of about $130 billion. Its ROE = $25 billion / $130 billion = 0.19 x 100 = 19%, which means the company’s X annual net income is about 19% of its shareholders’ equity.
The notion of an operating margin is sometimes used as ROS. The only difference is that ROS calculates its operating profit as EBIT while the operating margin focuses on operating income. The latter shows the revenue and cost of running a company without non-operating income or expenses, such as taxes, interest expenses, and interest income.
Here’s how you can calculate the operating margin.
Return on sales is an important metric for any business showing how effectively the company uses its sales resources to generate revenue.
Businesses use multiple approaches to improve their ROS. One of them is to increase the product price, provided the company delivers a stronger customer experience or warranty on its products, unlike its competitors.
Another option for companies is to improve ROS by assessing how they manufacture products. For instance, selling abroad might lead to long-term savings, bringing a greater return.
Finally, you can improve your ROS by optimizing your sales processes using current automated tools like Snov.io free CRM ecosystem to equip your sales team with ready-made solutions and keep track of all sales cycles.
Still struggling with the ROS formula? Here are several platforms where you can calculate ROS online: Omni Calculator, GIGAcalculator.com, and Online Calculator.
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