The return on sales ratio is an accounting metric that measures a company’s net income against net sales. It is used to determine a company’s profitability. While a higher sales ratio is always better, analyzing a company’s sales ratio should be done with an industry perspective, as sales ratios can vary among industries.
Divide a company’s net income by its net sales to obtain the return on sales ratio. Net income is the amount of profits left over after subtracting all business losses from gross revenues; these subtractions include operating expenses, such as payroll and supplies, taxes, depreciation on assets and interest paid. The net sales figure is a company’s revenue from sales after accounting for returns and discounts.
As an example, assume a company sells a single product for $10. In one fiscal quarter, the company sells 1,000 units, and 1 percent of them are returned. Gross sales are $10,000, and the value of returned items is $100; in this example, net sales are $9,900. If the company paid $2,000 in payroll, $1,000 in taxes, $1,000 in equipment, $500 in interest and $1,500 in miscellaneous expenses, then the company’s net income is $9,900 - $2,000 - $1,000 - $1,000 - $500 - $1,500, or $3,900. The return on sales ratio is 3900 / 9900, or 0.39.
In his book “How to Read a Financial Report,” John Tracy advises investors to be aware that the net sales ratio can differ from one company to another, depending on the industries involved. Stephen Hammerstein, in his franchising guidebook, notes that it is not uncommon for service-oriented companies to frequently have sales ratios of 85 percent, whereas manufacturers often have a sales ratio of 35 percent or lower.
The sales ratio is a good measure of a company’s profitability, but it should not be considered in a vacuum. For example, a business that has a lot of appreciating assets, like shares of stock, will have value that is not captured by the sales ratio, as the value of those assets is not captured in sales numbers. Hammerstein warns potential business owners to evaluate a sales ratio by comparing it to a business’s inventory turnover. For example, many retail-oriented companies have low sales ratios but may still be profitable and well-run because their inventory turnovers can be as much as 30 times higher than in other industries.