Gross Profit Ratio  What is the Gross Profit Ratio?

Gross profit ratio is a profitability measure that is calculated as the ratio of Gross Profit (GP) to Net Sales and therefore shows how much profit the company generates after deducting its

Gross Profit Ratio Formula

Gross Profit = Net Sales – Cost of Goods Sold

Now, for obtaining gross profit by using the above equation, we need to find out two other values, i.e., Net Sales and .

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

Net Sales = Sales –

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 GP Ratio as follows:

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

(usually expressed in the form of a percentage)

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

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)
• , 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:

You can download this Gross Profit Ratio Excel Template here – Gross Profit Ratio Excel Template

Finally,

#4 – Gross Profit Ratio Formula

Let us now move on to the significance and implications of the Gross Profit Ratio.

• By comparing 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 .
• 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, the 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 .

Limitations

• It does not take into account the expenses which are incurred by the company that is usually charged off to the .
• It is only a passive indicator of the overall status of the company. A company may have a positive gross profit margin, but when are reduced, the resultant profit might be quite less, or sometimes, the company may be running in losses. So the is not a metric on which the entire 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 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 , 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.

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