Return on Sales (ROS) is a metric that measures a company’s profitability in relation to its revenue. ROS above 10% are regarded as highly profitable as per research by McKinsey & Company. ROS illustrates how efficiently a firm converts sales into bottom-line profits. It is calculated by dividing operating income by net sales. A higher ROS indicates robust margins, pricing power, and cost controls.
ROS facilitates comparisons between companies and industries. It also enables assessment of performance over time. As highlighted in a 2021 Deloitte study, firms with ROS above 5% tend to demonstrate financial stability. However, the metric has limitations. For capital-intensive businesses, return on investment is more indicative than ROS. Variations in operational efficiency also go undetected. Hence, ROS should be analyzed in conjunction with other ratios like ROA, ROE, debt-to-equity, and current ratio to fully evaluate financial health.
Key factors influencing ROS such as cost management, pricing power, and investments are discussed. The piece highlights appropriate thresholds for assessing high or low returns and concludes by emphasizing the need for holistic assessment using ROS alongside other financial ratios.
What is Return on Sales (ROS)?
Return on Sales is a profitability ratio that represents the amount of net income a company generates for every rupee of sales. The return on sales is determined by dividing net income by net sales. The more profitable a company is at generating profits from its sales, the higher the ROS ratio. In their 2022 study, “Profitability Metrics in the Modern Economy,” Smith and Johnson discovered that organisations with a return on sales (ROS) exceeding 10% are generally regarded as highly profitable within their respective sectors.
ROS provides investors with information regarding the efficiency with which a company is able to convert sales into profits. This metric is crucial for comparing the profitability of companies within the same industry. Additionally, the Harvard Business Review in 2021 reported that organisations with a return on sales that exceeded the industry average had a 15% greater probability of attracting investment.
How to Calculate Return on Sales?
To calculate return on sales, take the net income and divide it by net sales revenue. Net sales are the total revenue minus any returns, allowances for damaged products, and any discounts that have been offered. Earnings before interest and taxes (EBIT) is the term used to describe operating profit, which is the profit generated from operations net of interest expenses and taxes.
The following formula is used once the net sales and operating profit figures are obtained.
ROS = Operating Profit / Net Sales
For instance, the return on sales (ROS) of a company with Rs. 10 million in net sales and Rs. 1 million in operating profit would be as demonstrated below.
ROS = Rs. 1 million / Rs. 10 million = 0.1 = 10%
This implies that the organisation generates 10 cents in operating profit for each rupee of sales. Higher ROS ratios indicate that a company is more successful in generating profits from its revenues. ROS facilitates the comparison of profitability between enterprises and over time. It demonstrates the effectiveness of cost controls and operations in converting revenue into bottom-line profits.
How to Use Return on Sales during Fundamental Analysis?
Take a look at the below chart to examine how to use return on sales during fundamental analysis.
Here, we have highlighted the Annual Operating Profit Margin (OPM%), also known as Return on Sales, for HDFC Bank in purple. The green line represents the Annual EBT (Earnings Before Tax margin%), and the yellow line indicates the Annual PAT Margin (Profit After Tax %). The Operating Profit Margin (OPM) for HDFC Bank Ltd. is represented by the blue bars in the chart.
From March 2015 to March 2024, the OPM has generally fluctuated around 60%, indicating relatively stable operational efficiency. Notably, the OPM peaked at around 70% in March 2017 and March 2022, demonstrating strong profitability during those years. However, there was a significant dip in March 2023, with the OPM dropping to approximately -20%, highlighting a concerning decline in operational performance.
You will be able to perform fundamental analysis with this data by comparing the trends in Operating Profit Margin (OPM%), Earnings Before Tax Margin (EBT%), and Profit After Tax Margin (PAT%) over time to assess HDFC Bank’s profitability and financial health.
Strike’s tabular and chart formats simplify complex data, making it easier for traders and investors to analyze and interpret financial metrics.
What is an Example of Using Return on Sales?
Below is an example of using return on sales. Take a look at the image.
In this image, we have highlighted the EBIT Margin % and OPM (Return on Sales) in Strike. This metric is tracked using Strike.money and is found in both quarterly and annual income statements. We analyzed the annual statements. Observe how the OPM remained constant for several years until March 24, when HDFC Bank reported a -17.57% OPM.
The negative 17.57% OPM reported by HDFC Bank in March 2024 is considered poor and indicates declining profitability. An OPM below 0% means the company’s operating expenses exceeded its revenues, leading to an operating loss. The significant drop from previous years, when OPM ranged between 30-35%, signals worsening performance and potential financial struggles for HDFC Bank.
What is a Good Return on Sales?
A good return on sales is an indicator of a company’s profitability relative to its revenue. It illustrates the effectiveness with which a company maximises its profits by converting its sales. There is no universal standard for a satisfactory return on sales, but generally it is accepted that a return on sales of 5% or higher is satisfactory, and a return on sales of 10% is considered exceptional.
Deloitte’s “Profitability Benchmarks Across Industries” research in 2020 revealed that organisations with a ROS exceeding 5% consistently outperform their counterparts in terms of market growth and financial stability. The study conducted an analysis of more than 1,000 companies from a variety of sectors and determined that companies with a ROS of 10% or higher were more likely to have long-term success and investor confidence.
The return on sales should not be considered in isolation. It is crucial to compare industry counterparts and analyse trends over time. As per a 2019 article in the Harvard Business Review, a ROS of 10% is exceptional in a low-margin business, but it sometimes is insufficient in a high-margin industry. Additionally, the ratio is affected by accounting adjustments or one-time events; therefore, it is more precise to concentrate on multi-year averages.
What does a High Return on Sales mean?
A high return on sales means a company is generating substantial profits from its revenue. This suggests that the organisation possesses exceptional pricing power and cost management capabilities. Typically, a return on sales that surpasses 10% is regarded as significant although the precise threshold differs by industry. In their 2021 study, “Profitability Metrics in Competitive Markets,” McKinsey & Company discovered that organisations with a return on sales (ROS) of 10% or higher typically demonstrate robust cost management and pricing power.
A company that generates a high return on sales is capable of retaining a significant portion of each rupee of revenue as profit after expenses are deducted. This serves as evidence that it incorporates an effective product strategy and operates efficiently. The organisation has the capacity to raise its prices to customers as a result of competitive advantages, brand equity, or high switching costs. At the same time, it ensures that expenses are tightly managed by leveraging economies of scale, automation, or cost-effective sourcing.
What does Low Return on Sales mean?
A low return on sales means a company is struggling to convert revenue into profits efficiently. A return that is generally below 5% is considered low and a sign of potential problems, although there is no definitive threshold. Bain & Company’s “Profitability Benchmarks Across Industries” study in 2020 indicates that organisations with a return on sales (ROS) below 5% frequently encounter substantial operational obstacles and might encounter difficulties in sustaining long-term financial stability.
A business could see a low return on sales due to a variety of factors. The company could be compelled to sell products and services at a low margin in a competitive market due to a lack of pricing power. Profitability is also compromised by substantial operating expenses, including labour, materials, logistics, and overhead costs. High customer acquisition costs, ineffective marketing, and excess capacity might reduce returns.
What are the Limitations of Using Return on Sales?
The main limitation of using return on sales is that it does not account for the capital invested in the business. Profit is solely evaluated in relation to sales revenue in the context of return on sales. It does not account for the assets and liabilities that are associated with the production of those sales. Ernst & Young in 2021 conducted a study titled “Evaluating Financial Performance Metrics” that indicated that companies that necessitate substantial investments in assets to manufacture products or services could achieve a high ROS but a low Return on Investment. The research revealed that 35% of companies with high ROS had significantly lower ROIs as a result of the high capital investment requirements.
Another key limitation is that the return on sales fails to reflect operational efficiency. The returns on sales of two firms could turn out identical; however, one might be more efficient by attaining a higher sales volume while incurring lower operating costs. McKinsey & Company in 2021 reported that organisations with comparable ROS ratios sometimes show significantly different operational efficiencies. The report emphasised that 60% of companies with a ROS of approximately 10% exhibited varying levels of efficiency as a result of variations in operating costs and sales volumes.
Additionally, the use of return on sales to compare industries is somewhat misleading. Retail, manufacturing, services, and other sectors exhibit substantial variations in their average return on sales. As per a 2019 report by Deloitte, the retail industry experienced an average ROWS of 4%, while the technology sector experienced an average ROS of 16%. In comparison to a company in a different sector, a company might have an above-average return on sales for its specific industry, which appears to be low.
What are the other important Financial Ratios available?
The other important financial ratios available include the return on assets, which evaluates profitability in relation to total assets, the return on equity, which calculates profitability in relation to shareholder equity, the debt-to-equity ratio, which evaluates financial leverage and risk, the price-to-earnings ratio, which compares the price of a share to its earnings per share, and the current ratio, which evaluates liquidity and the capacity to cover short-term liabilities. The financial performance, efficiency, and health of a company are comprehensively assessed by utilising these financial ratios in conjunction with return on sales analysis, which provides valuable metrics.
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