While strong sales revenue is good for a business, it is important to retain as much of that money as possible after paying expenses. The return-on-sales ratio, or profit margin, measures your profit as a percentage of sales revenue and reveals the amount you keep for every dollar of sales. You can use this ratio to determine how well your small business manages its costs.
Net income, or profit, equals total revenue minus total expenses. Revenue is money generated from selling your products and services. Expenses include wages, rent, interest, income taxes, the costs to make or buy your inventory and any other costs you incur during a period to run your business. If total expenses exceed revenue, your business has a net loss. For example, if your small business has $500,000 in revenue and $400,000 in total expenses during the year, your net income would be $100,000.
The return-on-sales ratio equals net income divided by revenue, times 100. If your small business has a net loss for the period, the ratio will be negative. Using the figures from the previous example, your return-on-sales ratio would equal 20 percent, or $100,000 in net income divided by $500,000 in revenue, times 100. This means your business kept 20 cents of profit for every dollar of sales produced during the year.
Acceptable return-on-sales ratios vary among industries. To gauge the strength of your ratio, compare it over different accounting periods and with those of your competitors. A rising ratio suggests your small business is increasing its efficiency. If your ratio exceeds the industry average, you might have a competitive advantage over your peers. For example, if your ratio rises from 20 to 22 percent and the industry average is 19 percent, your small business’ profitability is in good shape.
Another version of the return-on-sales ratio formula uses operating profit instead of net income. Operating profit measures your core business performance without the effects of debt and income taxes. This profit equals revenue minus expenses, excluding interest and income taxes. Assume you have $500,000 in revenue and $350,000 in expenses excluding interest and taxes. Your operating profit is $150,000. Your return-on-sales ratio is 30 percent, or $150,000 divided by $500,000, times 100. You earn 30 cents for every dollar of sales before paying interest and taxes.
