What is the Gross Profit Ratio?
Gross profit ratio is calculated as the ratio of Gross Profit (GP) to Net Sales and shows how much profit the company generates after deducting its cost of revenues.
Gross Profit Ratio Formula
Let us see how Gross Profit can be calculated.
Now, for obtaining gross profit by using the above equation, we need to find out two other values i.e. Net Sales and Cost of Goods Sold.
First, let us look into the value ‘Net sales’.
The next value we need to obtain is the ‘Cost of Goods Sold’.
*Purchases imply Net Purchases i.e. Purchases minus Purchase Returns.
After obtaining all the above values, we can now compute the GP Ratio as follows:
4.9 (1,067 ratings)
(usually expressed in the form of a percentage)
From the above computations, we can say that we require the following values in order to obtain the Gross Profit Ratio:
- Total Sales
- Sales Returns (If any)
- Opening Stock of Goods
- Purchases made during the period
- Purchase Returns (If any)
- Closing stock i.e., Stock at the end of the period for which we are computing the ratio.
- Direct Expenses Incurred.
As we can see, all these amounts can be picked up from the Trading Account of a concern.
Gross Profit Ratio Examples
Let us understand the calculation of gross profit ratio with the help of an example:
#1 – Net Sales
#2 – Cost of Goods Sold (COGS)
#3 – Gross Profit
#4 – Gross Profit Ratio Formula
Let us now move on to the significance and implications of the Gross Profit Ratio.
Advantages of the Gross Profit Ratio
- By comparing the net sales of the business with the gross profit of the company, the GP Ratio will enable the users to know the margin of profit that the company is earning by the trading and manufacturing activity.
- It determines how much the company is earning in excess of the amount it has to pay for its operating expenses.
- It helps in Inter-Firm comparison of the results of trading activity.
- Gross Profit tells how a company is doing better or worse in comparison to its competitors because the higher the efficiency of a company, higher is the gross profit.
- It determines the edge the company has in the market.
- Comparing the trend of the Gross Profit ratio over the years helps in determining the rate of growth of the company.
- This margin allows in creating budgets and forecasts.
Limitations of the Gross Profit Ratio
- It does not take into account the expenses which are incurred by the company that is usually charged off to the Profit and Loss Account.
- It is only a passive indicator of the overall status of the company. A company may have a positive gross profit margin but when all other expenses are reduced, the resultant profit might be quite less or sometimes, the company may be running in losses. So the gross profit percentage is not a metric on which the entire profitability of the company can be measured or judged.
Important Points to Remember about GP Ratio
If the analysis of the Gross Profit trend indicates an increase in the percentage, we can arrive at any of the following conclusions:
- The value of the Opening Stock is understated or the value of the Closing Stock is overstated.
- There is an increase in the selling price of the goods without a corresponding increase in the cost of goods sold.
- In a similar manner, there is a decrease in the cost of goods sold without a corresponding decrease in the selling price of the goods.
- There must have been errors while recording the purchases or sales figures. Purchases might have been omitted or sales figures might have been recorded in excess than the actual sales made i.e. boosted.
If the analysis of the Gross Profit trend indicates a decrease in the percentage, we can arrive at any of the following conclusions:
- The value of the Opening Stock is overstated or the value of the Closing Stock is understated.
- There is a decrease in the selling price of the goods without a corresponding decrease in the cost of goods sold.
- In a similar manner, there is an increase in the cost of goods sold without a corresponding increase in the selling price of the goods.
- There must have been errors while recording the purchases or sales figures. Sales might have been omitted or purchase figures might have been recorded in excess than the actual sales made i.e. boosted.
In short, Gross Profit (GP) ratio is a measure that shows the relationship between the Gross Profit earned by an entity and the Net Sales of the company in a manner that what portion of the Net sales is achieved as the Gross Profit of the company. Though it is a popular and widely used tool for evaluating the operational performance of the business, it is not a complete measure for judging the overall functioning of the company. What would be more useful is the Net Profit Ratio because it takes into account all other expenses also which we shall learn about in another article.
This has been a guide to What is a Gross Profit Ratio and it’s Meaning. Here we discuss the formula to calculate Gross Profit ratio examples along with advantages and disadvantages. You can learn more about Accounting from the following articles –