This financial ratio is used to show how efficient a company is at using its revenue in order to generate profits. Also called the operating profit margin, return on sales determines a certain company’s performance by showing what exact percentage of total company revenues are converted into company profits.
As this financial ratio shows exactly the amount of money, in percentages, that the company makes using its revenues during a certain period, return on sales is something that creditors and investors are interested in.
For example, investors and creditors will compare two different periods within the same company to see if it has evolved in terms of generating profit, or they’ll compare two different companies in order to see how they perform in a time period – and, obviously, see which one performs better.
The Basics of Return on Sales
First of all, when using return on sales to compare two companies, those two companies can be of different sizes – it doesn’t matter if one has more money than the other, it matters how efficiently one uses its revenue to generate profits.
Therefore, creditors and investors will make use of return on sales in order to analyze the performance trends of a certain business and compare them with other companies that activate in the same industry, as well.
For example, we could take one of the richest companies in the world and compare it with a local/ regional firm. Return on sales would show us which one of those two is more efficient at generating profits from revenue, without taking into account any non-operating activities of the chosen companies.
How to Calculate the Return on Sales
If we want to come up with the return on sales of our company, all we have to do is divide the operating profit by the net sales for the period we have chosen to analyze.
Of course, you must remember that non-operating activities, such as structure financing and taxes are not taken into account within the formula. These two are not included in the calculus because they do not fall in the operating expenses category.
Basically, creditors and investors, through return on sales, are able to focus on the core operations of a company/ business and see if the operations of a company are indeed profitable or not.
So, the return on sales determines which percentage of a company’s sales is converted into actual income. Therefore, it also determines if a company is efficient at producing its core services or products and how effective is it being run by the management team, as well.
Moreover, return on sales is also used to measure a company’s operating profitability – because, if efficiency and revenues increase, so do the profits.
Investors often use the return on sales formula in order to come up with forecasts and calculate growth projects. Basically, if a certain percentage is taken into account and analyzed, an investor can calculate the potential profits of a certain company if its revenues doubled or tripled in a certain time period.