Gross Profit Ratio

What Is the Gross Profit Ratio?

The gross profit ratio is a profitability measure calculated as the gross profit (GP) ratio to net sales. It shows how much profit the company generates after deducting its cost of revenues. It is a percentage of revenue that exceeds the cost of goods sold.

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For eg:
Source: Gross Profit Ratio (wallstreetmojo.com)

Thus, it is a measure of the efficiency of the production process, which indicates how well the company manages the cost and the margin that is available to meet all the operating expenses. It does not consider the selling, general or administrative expenses. Thus, it gives us a good idea about the gross profit efficiency but does not provide a complete profitability view.

Gross Profit Ratio Explained

The gross profit ratio is also known as the gross profit margin which tells us how much percentage of revenue is more compared to the cost of goods sold. Thus, before taking into account the operational expenses, the metric measures the effectiveness of the production process.

It is useful to the management and creditors, shareholders and investors to calculate gross profit ratio because it allows the company to compare itself with the competitors and peers in the market. The higher the raio, the better is the company’s ability to control cost. Thus, it indicates the skill and competence of the management.

It also shows the ability of the business to cover other operating expenses. Since it indicates the proficiency of the ccompany, it is widely used by the management to forecast the prices and design pricing strategy for increasing sales and revenue while at the same time remaining in the competition by charging a reasonable price.

It is important for the company to calculate gross profit ratio and monitor the ratio over time so that it is possible to note the changes. The changes in the ratio will highlight the trends and fluctuations that should be taken into account and accordingly adjust the production and operational process to achieve the maximum profit through cost control.

Formula

Let us see how to calculate Gross ProfitGross ProfitGross Profit shows the earnings of the business entity from its core business activity i.e. the profit of the company that is arrived after deducting all the direct expenses like raw material cost, labor cost, etc. from the direct income generated from the sale of its goods and services.read more.

Gross Profit = Net Sales – Cost of Goods Sold

To obtain gross profit using the above equation, we need to find two other values, i.e., net sales and cost of goods soldCost Of Goods SoldThe Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. read more.

First, let us look into the value of ‘net sales.’

Net Sales = Sales – Return InwardsReturn InwardsReturn Inward, also known as sales return, refers to the goods returned to the business entity when the customers find that the goods delivered did not meet their expectations and, therefore, unsatisfactory.read more

The next value we need to obtain is the ‘cost of goods sold.’

Cost of Goods Sold = Opening Stock + Purchases*- Closing Stock + Any Direct Expenses Incurred

*Purchases imply net purchases, i.e., purchases minus purchase returns.

After obtaining all the above values, we can now compute the ideal gross profit ratio as follows: –

Gross Profit Ratio Formula = (Gross Profit/Net Sales) X 100

(Usually expressed in the form of a percentage)

From the above computations, we can say that we require the following values to obtain the ideal gross profit ratio: –

• Total Sales
• Sales Returns (If any)
• Opening Stock of Goods
• Purchases made during the period
• Purchase Returns (If any)
• Closing stockClosing StockClosing stock or inventory is the amount that a company still has on its hand at the end of a financial period. It may include products getting processed or are produced but not sold. Raw materials, work in progress, and final goods are all included on a broad level.read more, i.e., inventory at the end of the period for computing the ratio
• Direct Expenses Incurred.

As we can see, one can pick up all these amounts from the trading account.

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Examples

Let us understand the calculation of the gross profit ratio with the help of an example: –

#1 – Net Sales

#2 – Cost of Goods Sold (COGS)

#3 – Gross Profit

Finally,

#4 – Gross Profit Ratio Formula

Let us now move on to the significance and implications of the gross profit ratio.

Importance

Let us try to identify the importance of the financial concept of gross profit ratio analysis in detail.

• By comparing net sales Net Sales Net sales is the revenue earned by a company from the sale of its goods or services, and it is calculated by deducting returns, allowances, and other discounts from the company's gross sales.read more with the company’s gross profit, the gross profit ratio will enable the users to know the profit margin that the company is earning from the trading and manufacturing activity.
• Gross profit ratio analysis determines how much the company makes more than the amount it has to pay for its operating expensesOperating ExpensesOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit.read more.
• It helps in inter-firm comparison of the results of trading activity.
• Gross profit tells how a company is doing better or worse than its competitors because the higher the efficiency, the higher the gross profit.
• It determines the edge the company has in the market.
• Comparing the gross profit ratio trend over the years helps define the company’s growth rate.
• This margin allows for creating budgets and forecastsBudgets And ForecastsWhile Budgeting refers to planning the business revenues & expenditures for a specified period, Forecasting means predicting the future outcomes by analyzing historical & present trends. read more.

Limitations

The concept of good gross profit ratio also has some important limitations that should be noted carefully. Let us examine them.

• It does not consider the company’s expenses usually charged to the profit and loss accountProfit And Loss AccountThe Profit & Loss account, also known as the Income statement, is a financial statement that summarizes an organization's revenue and costs incurred during the financial period and is indicative of the company's financial performance by showing whether the company made a profit or incurred losses during that period.read more.
• It is only a passive indicator of the company’s overall status. For example, a company may have a positive gross profit margin. Still, when all other expenses All Other ExpensesOther expenses comprise all the non-operating costs incurred for the supporting business operations. Such payments like rent, insurance and taxes have no direct connection with the mainstream business activities.read more reduce, the resultant profit might be quite less, or sometimes, the company may be running in losses. So, the gross profit percentageGross Profit PercentageGross profit percentage is used by the management, investors, and financial analysts to know the economic health and profitability of the company after accounting for the cost of sales. Gross profit percentage formula = Gross profit / Total sales * 100% read more is not a metric on which the entire profitability of the companyProfitability Of The CompanyProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance.read more can be measured or judged.

Interpretation

If the analysis of the gross profit trend indicates an increase in the percentage, we can arrive at any of the following conclusions: –

• The opening stockOpening StockOpening Stock is the initial quantity of goods held by an organization during the start of any financial year or accounting period. It is equal to the previous accounting period's closing stock, valued in accordance with appropriate accounting standards based on the nature of the business.read more 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.
• Similarly, there is a decrease in the cost of goods sold without a corresponding reduction in the selling price.
• There must have been errors while recording the purchases or sales figures. For example, the buys might have been omitted, or sales figures might have been recorded more than the actual sales, i.e., boosted.

Suppose the gross profit trend analysis indicates a decrease in the percentageDecrease In The PercentageDecrease Percentage is used to determine the decrease in two values (final value and initial value) in percentage terms and according to the formula the initial value is subtracted from the final value and the resultant is divided by the initial value and multiplied by 100 to derive the decrease percentage.read more. In that case, 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 reduction in the cost of goods sold.
• Similarly, 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. For example, sales might have been omitted, or purchase figures might have been recorded more than the actual sales, 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 company’s net sales in a manner that what portion of the net sales is achieved as the company’s gross profit. 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 company’s overall functioning. The net profit ratio would be more useful because it considers all other expenses, which we shall learn about in another article.

Gross Profit Ratio Vs Net Profit Ratio

Both the above concepts are important financial metrics that give a very precise idea about the financial condition of the company. However, there are some points of differences between them as follows:

• The good gross profit ratio measures the company’s efficiency level regarding production or purchasing process for the purpose of profit generation but the latter refers to the part of an unit of dollar that remains as profit in the business.
• The former indicates how efficiently the company is able to manage the cost of production and purchasing processwhereas the latter indicates the overall profitability of the business after taking into account all the expenses that it incurs for running the business operation.
• As derived from the above points, the former takes into account the relation between the gross profit and net sales only without considering the operating expense, whereas the latter accounts for all expenses including operating expense, tax, interest, etc.
• If the former is high, it reflects that the company is able to manage the production cost of the business efficiently. If the latter is high, it indicates that the profit earning capacity of the company is high with respect to the sales made.

Thus both are very good measures of the company’s financial condition which is useful  not only for the management but also for the stakeholders who use this information to take investment decisions.

Frequently Asked Questions (FAQs)

Recommended Articles

This article is a guide to what is Gross Profit Ratio. We explain the formula, interpretation, example, importance & differences with net profit margin. You can learn more about accounting from the following articles: –

• Loss Ratio
• Purchase Return Journal Entry
• Contribution Margin vs. Gross Margin
• Compare – Gross Income vs. Net Income