What is Return on Sales?

The return on sales is a ratio used to derive the proportion of profits generated from sales. The concept is useful for determining the ability of management to efficiently generate a profit from a given level of sales. An increasing return indicates an improvement in operating efficiency, as well as the presence of product branding that allows an organization to charge higher prices for its products and services. Conversely, a recurring decline in the return on sales is a strong indicator of impending financial distress, possibly due to product commoditization or declining efficiencies.

How to Calculate the Return on Sales

The return on sales formula is earnings before interest and taxes, divided by net sales. The calculation is:

Earnings before interest and taxes ÷ Net sales = Return on sales

Because of the exclusions relating to finances and taxes, the result of the ratio is the proportional return on those sales generated by core operations. This information is most useful when tracked on a trend line, to determine the ability of management to earn a reasonable return on a given sales volume. A possible outcome to look for is that the return cannot be sustained as sales increase, because management is forced to look into less-profitable niches to find sales growth opportunities. This results in a gradual decline in the return on sales.

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Understanding the Return on Sales

The return on sales concept can also be applied to industry analysis, to determine which companies within an industry are being most efficiently run. Those with the highest returns are likely to attract the highest buyout offers from potential acquirers. However, when conducting this analysis, verify that the calculation of net sales and earnings provided by each business are devised in the same way - which is not necessarily the case.

Example of the Return on Sales

A business reports net profits of $50,000, interest expense of $10,000, and taxes of $15,000. The net sales reported for the same period is $1,000,000. Based on this information, the return on sales is 7.5%, which is calculated as follows:

($50,000 Earnings + $10,000 Interest + $15,000 Taxes) ÷ $1,000,000 Net sales

= 7.5% Return on sales

Problems with the Return on Sales

There are several issues with the return on sales concept, which are as follows:

Ignores financial leverage. The return on sales does not factor in the effects of financial leverage, such as a large interest expense obligation, and so tends to overstate the returns being generated by a business. Thus, a highly-leveraged company that reports a strong return on sales might still face financial distress if it struggles to service its debt.
Only focuses on profitability. The return on sales metric is only focused on the profitability of a business. It does not measure liquidity, risk, or cash flow, which are also critical underpinnings of the financial health and overall stability of an organization. Thus, a business that reports an impressive return on sales might still go bankrupt, because it does not have enough cash flow to maintain its sales growth.
Can be manipulated. The return on sales measurement can be altered by changing a firm’s accounting policies, or by fraudulently altering accounts that impact sales or profits. These adjustments can yield a substantially different return on sales figure. For example, an accountant does not accrue expenses for a reporting period, resulting in an inflated profit and therefore an inflated return on sales for that period.