Profitability and Coverage Analysis
2.1. Return on sales (ROS)
Return on sales (ROS) (also known as operating profit margin) shows the effectiveness of a company’s operating activity in relation to its sales. This ratio shows how much profit a company generates per dollar of sales and is calculated by dividing operating profit by total sales.
The higher the return on sales is, the better because every additional dollar of sales produces more profit. Depending on the purpose of financial analysis, return on sales (ROS) can be viewed as follows:
- From management standpoint (comparing return on sales for the current and prior periods): when ROS increases, activities of a company are viewed as effective, and when ROS decreases, on the contrary, the company’s activities are seen as ineffective.
- From investment standpoint (comparing return on sales to an industry average): more profitable companies have higher ROS (because such companies are more effective) while less profitable companies have lower ROS.
Return on Sales (ROS) Formula
Depending on the purpose of analysis, the return on sales calculation can use different indicators of a company’s profitability: gross margin, operating profit, income before taxes or net income. We will look at the calculation with two of such indicators: operating profit and net income.
Return on sales (ROS) calculated by dividing operating profit by total sales is as follows:
Return on Sales (ROS) = |
Operating Profit |
x 100% |
Total Sales |
Return on sales (ROS) calculated by dividing net income by total sales is as follows:
Return on Sales (ROS) = |
Net Income |
x 100% |
Total Sales |
Operating profit is the difference between the gross margin and selling and administrative (operating) expenses.
Net income (also called net profit or earnings) is the excess of revenues over expenses for a period.
Total sales (or revenue) represent an increase in assets (e.g., cash sale) or decrease in liabilities (e.g., recognition of unearned service revenue as earned revenue) resulting from the operating activities of a company.
Return on Sales (ROS) Example
In our example of Friends Company, to determine its return on sales, we will use the consolidated income statements available at the end of this tutorial. The return on sales for fiscal year 20X9 can be calculated as follows:
Return on Sales (Operating Profit) = |
$4,280 |
x 100% = 30.6% (rounded) |
$14,000 |
Return on Sales (Net Income) = |
$2,700 |
x 100% = 19.3% (rounded) |
$14,000 |
The results indicate that every dollar of sales generates 30.6 cents of operating profit and 19.3 cents of net income. As you can see, using net income instead of operating profit in the formula provides a lower return on sales. This should be considered in interpreting results of return on sales calculations.
Important Notes
When evaluating and analyzing the return on sales ratio, it is important to consider the following factors:
- Return on sales ratio varies from industry to industry. A lower return on sales would be expected for those companies that work with a great amount of transactions and have significant price pressures (e.g., retail companies). On the other hand, companies that operate in industries with more expensive and unique products (car dealers, jewelry stores, etc.) and that have fewer transactions would have a higher return on sales ratio.
- As was mentioned above, different indicators (operating profit before subtracting interest and taxes, after-tax income) can be used in relation to total sales when calculating the return on sales ratio. Different indicators are acceptable; however, it is important that the return on sales calculations are consistent in what indicator they use for a particular analysis.
- Return on sales ratio can be inflated, and therefore, it can be a misleading measure of profitability if the profit data used in its calculation includes special allowances and extraordinary non-regular items.