Return on sales is an important key performance indicator for companies. It evaluates how economically a company operates. If you know how to interpret it, it can provide important insights into business processes and thus uncover optimization potential. We’ll explain everything you need to know about return on sales and give you useful tips on how to increase it in your company.
What does return on sales indicate?
If the return on sales is high, this means that only a small portion of the revenue generated is used to cover ongoing costs. This is a very positive signal. Depending on the high return on sales, a company can easily increase expenses and still achieve a good result. If the return on sales is low, however, companies are financially weak and therefore particularly vulnerable in emergency situations.
Return on sales vs. return on capital
It’s important not to confuse return on sales with return on capital. While both relate to the company’s profit, return on capital focuses on capital: “How much capital does the company need to use to generate X amount of revenue?”
Calculating return on sales: This is the formula
Return on sales is the essence of a financially healthy company, the foundation of a solidly built house, so to speak. But how exactly do you calculate your company’s return on sales? There are several formulas available for this calculation, such as the following.
Return on sales (in %) = (profit/sales) * 100
Another formula for calculating return on sales would be to replace profit/net income after tax with profit before tax.
Example calculation for return on sales: Let’s assume your company has annual sales of $150,000 and a profit of $13,500. This would give a return on sales of 9%. However, if the profit were higher with the same sales (for example, due to lower costs), the return on sales would immediately rise to 20%.
By the way: A return on sales can also be negative! For example, if your company’s return on sales were -30%, you would spend $1.30 for every euro you’ve worked so hard to earn! A truly hellish ride. To avoid this, as an entrepreneur, you should definitely pay attention to your return on sales.
Profitability Interpretation: How high should it be?
The benchmarks for return on sales depend heavily on the industry. As a rule of thumb, you can remember that return on sales should of course be positive, otherwise, as in the example above, you’ll lose money every time you work. A return on sales of around 5% is already in a good league, and 10% is especially good.
A good way to interpret your own return on sales is to look at your competitors: How are other companies in your sector performing? Is your competitor’s return on sales higher or lower than yours?
Is your return on sales higher than your competitors’? Congratulations! Is your return on sales lower than your competitors’? Don’t let this situation depress you; instead, view this scenario as a challenge.
Getting to the bottom of low profitability
Do you perhaps have higher costs than your competitors? Are your prices much lower than theirs? Perhaps analyzing your return on sales will show you that it might be time to tweak your offerings and prices a little. Essentially, the guiding principle for improving your return on sales is simple: Earn more. Spend less. However, return on sales should be treated with caution as a key metric, as it does not always provide reliable conclusions, especially if the company has made investments to remain competitive in the long term.
7 reasons for weak return on sales
Insufficient sales
Low or insufficient sales are often the root cause of crisis, especially in startups or SMEs. Low sales are only the first problem, as they immediately lead to another: Insufficient sales make it difficult for the company to meet its financial obligations, such as fixed costs. Have you noticed insufficient sales in your company?
Then you should get to the bottom of this issue as well. It could be due to a new competitor, for example, or perhaps your offer isn’t attractive enough.
Have your sales continued to decline in recent months? Have your customers abandoned you? Get to the bottom of the facts and take a real stocktaking!
2. Poorly managed inventory
If you’re not in the service sector but sell goods, then you should definitely keep an eye on your inventory! Why? It’s simple: Too much inventory simply ties up your liquidity, your cash flow, and your profitability.
But it’s not just the products or items stored that are a factor: The space required for them (office storage, heating, electricity, etc.) also generates considerable costs. However, too little inventory also poses a risk, as a delivery delay threatens customer dissatisfaction or even customer loss, which isn’t exactly what you need when your financial situation is dire. So, as always, it’s important to find the right balance.
3. A margin that is too small
You should also always keep an eye on the margin achieved when selling your products or services. The sales margin is calculated as follows:
Sale of goods (excluding VAT) – Costs for the procurement of the goods sold (excluding VAT)
Why is the sales margin so important? Well, unfortunately, there are also companies that work incredibly hard, sell a lot, but somehow never quite make it. One reason for such a situation is that the sales margin is too low.
Remember: Selling a lot doesn’t necessarily mean earning a lot.
4. Excessive spending
On the other hand, even the best sales margin can’t save much if expenses are simply too high or fundamentally too uncontrolled. For example, if team members have access to their company card and treat themselves to the occasional restaurant or taxi ride during a client meeting, this can result in high costs in the long run, driving your profitability and thus the success of your company down the drain.
Among the classic reasons for (excessive) expenses in SMEs are:
- Rent
- Supplier contracts
- Electricity and water
- Insurance
- Various subscriptions that have been forgotten…
Our tip: Before you sign a contract, it is best to always compare with at least three providers.
5. Insufficient working capital
High sales volume doesn’t necessarily mean that cash flow is working well. Given this problem, it’s good to understand how to handle the concept of working capital. Working capital refers to the amount of money a company needs to cover its expenses before receiving its income. If the need for working capital exceeds the amount of working capital itself, cash flow problems will arise.
6. Crises and unforeseen events
There are many factors that can impact a business, and it’s good to know about them in advance, as things like natural disasters, pandemics, and the like can quickly deplete cash flow capital. Managers should find a balance between preparing the cash flow budget for such events and avoiding overforecasting.
7. A growth crisis
A growth crisis occurs when a company grows so rapidly that it no longer has sufficient material or human resources to fulfill its customers’ orders. These resources then need to be increased, which requires investments. However, these investments reduce cash flow, which cannot be addressed immediately.
Increase your profitability: How to do it
There are several adjustments you can make to increase your profitability. Here are some of them:
- Raise prices: Raising prices is a delicate balancing act, as it could potentially turn customers away. Therefore, it’s best to talk to your customers, give them hints about a possible price change, and explain the reasons for the increase. Only change the prices of those products where you generate the lowest profits.
– Optimize sales. Another solution is to increase sales. You can increase this by considering where you want to market your product. A physical store allows you to be closer to your customers, but this is associated with higher costs. Selling your products online can be logistically easier, more cost-effective, and ultimately more lucrative, depending on the product.
– Improve your communication strategy. Communication with customers is essential, so it’s important to know who your target audience is and how to reach them. Create personas of your target audience to better address individual potential customers within them. Then, maintain consistency in your communication strategy and stick to successful communication media.
– Reduce fixed costs: rent, telephone, electricity, etc. Cutting expenses is another way to get cash flow problems under control. If possible, gradually reduce your expenses, starting with fixed costs (rent, suppliers, etc.). Then focus on variable costs. This will give you a better overview of your expenses and allow you to reduce them more specifically.
– Apply for financing and subsidies. If cash flow difficulties do arise, a loan is the best option. However, during the loan application process, the banker must be convinced that you will be able to repay the loan. To do so, you will need to compile a comprehensive dossier. Of course, it’s important to note that the loan will incur additional financial burdens in the form of interest. It’s also possible to arrange an overdraft facility so that you’re optimally prepared in the event of liquidity problems.
You can also consider the following two options to continue financing your business despite cash flow problems:
Crowdfunding: On certain platforms, such as Kickstarter, you can present your business model and convince the platform’s users. They will then send you a specified amount of money.
Borrow Money: This should be a last resort. Ask your relatives and friends for the funds you need to cover your cash flow problems.
– Optimize deadlines. If cash flow problems arise, you must act quickly to ensure you can continue paying your invoices. Identify which customers are unreliable and be more strict with them when it comes to paying their invoices. In general, you also need to minimize late payments from your customers. Offer a discount on invoices if the customer pays promptly. Optimize your supplier management by trying to lower prices, giving preference to long-term partners, and leveraging this to your advantage.
– Better asset and inventory management. Leasing can be an excellent way to avoid overinvestment. It allows you to finance your assets more cost-effectively without having to make large investments, which could impact your cash flow.
– Avoid dormant inventory. This means that dormant inventory can lead to a reduction in your cash flow. Because the items are stored and not yet sold, your money is tied up there and no longer part of the cash flow.
To clear these inventories, you can offer discounts or market special offers. Avoid stockpiling and purchase only the amount of products necessary to sustain your business.