Return on Sales

What is return on sales?

Return on sales (German: Umsatzrentabilität, also Umsatzrendite) describes the ratio of an earnings figure to the revenue of the same period, expressed as a percentage. It is interpreted as the number of cents that remain as profit from each euro of revenue after deducting the expenses taken into account. If a bookseller is left with EUR 1 from a book costing EUR 20 after purchasing, rent, staff and all other costs, the bookseller's return on sales is 5%.

The ratio is one of the basic measures of financial statement analysis and of controlling, the planning and management of a company through figures. Banks use it in their creditworthiness rating, investors and buyers in comparison with other companies, and management teams in planning and monthly reporting. Because the law does not regulate the ratio, every statement needs to clarify which earnings figure stands in the numerator.

Calculating return on sales: formula and variants

Formula: Return on sales = earnings / revenue × 100%

Depending on the earnings figure in the numerator, different ratios with different purposes arise:

• Based on net income for the year: the net return on sales after interest and taxes. It shows what remains for the shareholders per euro of revenue, but depends on financing, tax position and one-off effects.
• Based on earnings before tax: suitable for comparisons across years with different tax burdens, for example when losses of earlier years are offset against profits (loss carry-forward); common in credit analysis.
• EBIT margin: earnings before interest and taxes, but after depreciation and amortisation, per euro of revenue, independent of financing. It is the usual measure for comparing operating earning power between companies and is explained in the entry on EBIT.
• EBITDA margin: earnings before interest, taxes, depreciation and amortisation per euro of revenue. It dominates in transactions and loan agreements, because EBITDA is the reference figure there for valuation and financial ratios.

Above these earnings figures stand two margins that deduct only part of the costs. The gross margin deducts from revenue the directly attributable costs of the services sold. The contribution margin ratio deducts the variable costs, that is, the costs that rise with volume (contribution margin). Neither is a profitability ratio in the narrow sense, but they explain how return on sales arises.

Drivers of return on sales: price, gross margin, fixed costs

Return on sales results from three levers. Price acts most directly: a price increase at unchanged volume raises revenue and earnings by the same amount, because costs remain essentially the same at the same volume. The gross margin determines how much of each additional euro of revenue remains after direct costs for the other expenses. The cost structure finally decides how strongly the return reacts to volume growth.

Companies with a high share of fixed costs, that is, costs incurred independently of volume, benefit disproportionately from growth. The same fixed costs are spread over more revenue (fixed cost degression). How strongly earnings react in percentage terms to a change in volume is described by operating leverage, the ratio of contribution margin to operating profit. It equals the reciprocal of the margin of safety to the break-even point. When revenue falls, the same lever works in the opposite direction.

Industries therefore differ markedly. Trading companies commonly work with low margins and high capital turnover, that is, they generate high revenue in relation to the capital employed. Software companies work with high gross margins; industrial companies lie in between, depending on capital intensity. Comparisons are meaningful only within one business model.

Return on sales in growth companies

Technology companies in the build-up phase often report a negative return on sales, because sales, product development and administration are set up for the expected business before revenue supports them. Investors therefore do not read a negative margin in isolation. They examine the path to profitability: whether the gross margin rises with scale and whether sales and administrative costs fall in relation to revenue. In addition there is the question of whether the unit economics, that is, the profitability per customer, are already positive.

A common condensation is the Rule of 40, which adds revenue growth in percent and margin in percent. A fast-growing company may accordingly report a negative margin as long as the sum of the two values is at least 40, for example 60% growth at a margin of minus 20%. As growth slows, the expectation shifts towards a positive return on sales, at the latest when a sale to a buyer who values on an earnings basis approaches.

Return on sales in the ROI ratio system

In the ROI ratio system (return on investment, the return on the capital employed), which breaks profitability down step by step into its components, return on sales is a factor of the return on total capital. Multiplied by capital turnover, that is, revenue divided by total capital (balance sheet total), it gives the return on all capital employed. This requires both calculations to use the same earnings figure, for example EBIT. The breakdown shows that a low margin can be offset by high capital turnover and vice versa. Via the ratio of total capital to equity, the chain continues to return on equity.

Worked example: return on sales in percent by earnings figure

A manufacturer of industrial software with hardware components achieves revenue of EUR 20.0 million. Variable costs amount to 50% of revenue; fixed costs, including depreciation and amortisation of EUR 0.8 million, amount to EUR 7.8 million. Interest expense is EUR 0.2 million, income taxes are EUR 0.6 million, and the balance sheet total is EUR 16.0 million.

• EBIT: 20.0 minus 10.0 minus 7.8 = EUR 2.2 million, EBIT margin 2.2 / 20.0 = 11%
• EBITDA: 2.2 plus 0.8 = EUR 3.0 million, EBITDA margin 15%
• Earnings before tax: 2.2 minus 0.2 = EUR 2.0 million, return on sales before tax 10%
• Net income for the year: 2.0 minus 0.6 = EUR 1.4 million, net return on sales 7%
• Price increase of 3% at the same volume: revenue EUR 20.6 million, EBIT 2.2 plus 0.6 = EUR 2.8 million, EBIT margin 2.8 / 20.6 = about 13.6%
• Operating leverage in the base case: contribution margin 20.0 minus 10.0 = EUR 10.0 million, divided by EBIT 2.2 = about 4.5
• Cross-check via the break-even point: break-even revenue 7.8 / 50% = EUR 15.6 million, margin of safety (20.0 minus 15.6) / 20.0 = 22%, reciprocal 1 / 0.22 = about 4.5
• Volume growth of 20% at the same prices and fixed costs: revenue 24.0, variable costs 12.0, EBIT 24.0 minus 12.0 minus 7.8 = EUR 4.2 million, EBIT margin 17.5%
• Increase in EBIT: (4.2 minus 2.2) / 2.2 = about 91%, a good 4.5 times the volume growth of 20%
• Capital turnover in the base case: 20.0 / 16.0 = 1.25; return on total capital on an EBIT basis 11% × 1.25 = 13.75%, corresponding to 2.2 / 16.0

Depending on the earnings figure, the return on sales of the same business lies between 7% and 15%. At the same time, the example shows the leverage effect of fixed costs: 20% more volume almost doubles EBIT. A price increase of only 3% raises EBIT by more than a quarter, because it arrives in full in earnings. Investors and buyers therefore look not only at today's margin but also at how strongly it rises with growth.

Distinction: gross margin, contribution margin and return on capital

• Gross margin: revenue less directly attributable costs in relation to revenue; it takes into account neither sales nor administrative costs.
• Contribution margin: revenue less variable costs; the basis for price and product range decisions, not for the profitability of the company as a whole.
• Return on equity: relates earnings to equity instead of revenue and is influenced by the financing structure.
• Return on total capital: earnings before interest on debt capital, for example EBIT, in relation to all capital employed; arithmetically the product of return on sales and capital turnover if both use the same earnings figure.

Common mistakes

• Earnings figure not stated. A return on sales of 10% is not comparable without stating whether net income, EBIT or EBITDA is meant.
• Revenue confused with total output. Total output includes, alongside revenue, changes in inventories and capitalised own work, for example self-developed software. Neither belongs to revenue; anyone who carries them in the denominator distorts the ratio.
• Comparisons across industries. Comparing the margin of a software provider with that of a retailer says little about the quality of either company.
• Negative margin without a path. Growth companies that report a negative return on sales without showing how and when it turns positive appear unconvincing to investors.
• Price effect underestimated. Discounts hit earnings in full. At a return on sales of 10%, a discount of 5% on total revenue costs half the profit.

Frequently asked questions

How is return on sales calculated?

As earnings divided by revenue times 100. A company with EUR 1.4 million of net income for the year and EUR 20 million of revenue has a net return on sales of 7%. It must first be decided which earnings figure stands in the numerator.

What is a good return on sales?

There is no universally valid benchmark. The yardstick is companies with a similar business model, similar size and similar capital intensity, as well as the company's own development over several years. How high the margin must be depends on capital turnover. A retailer that turns its capital over three times a year achieves a return on total capital of 12% with a 4% return on sales. A company with a capital turnover of 1 would need a 12% return on sales for that.

Benchmark values for individual industries such as crafts or hospitality are provided by business comparisons from chambers, associations and tax advisory firms.

Is return on sales the same as margin?

Largely yes. In everyday usage, EBIT margin, EBITDA margin and net margin count as variants of return on sales. The gross margin, by contrast, is not a return on sales in the narrow sense, because it deducts only the direct costs.

Why does return on sales fall despite rising revenue?

Because costs grow faster than revenue. Frequent causes are price discounts to win new customers, a rising share of lower-margin products or a build-up of staff that runs ahead of revenue.

How does return on sales affect the purchase price in a company sale?

Indirectly, through earnings. Buyers value on the basis of EBITDA or EBIT, so a higher margin at the same revenue increases the reference figure. Companies whose margin is above the industry average often also achieve higher multiples, that is, higher factors for converting earnings into enterprise value. The margin points to competitive advantages or pricing power.

The Roemer Capital view

For growth companies that we accompany through funding rounds, we show return on sales not as a single figure but as a development over the whole planning period. The financial model discloses which cost blocks grow with revenue and which do not, and thus makes visible at what level of revenue the margin turns positive.

This path becomes robust only through unit economics that support it. We therefore make sure that a ratio of customer lifetime value to acquisition cost of at least 3 to 1 and a payback of acquisition costs in under 12 months are evidenced. Investors then read a negative margin as an investment in growth and not as a structural problem.