How To Calculate The Gross Profit Ratio
Knowing a company's gross profit ratio can help you figure out how well it manages its resources. Regardless of what products or services a company sells, determining the best way to employ its labor and materials is likely to affect its long-term performance.
The gross profit ratio of a business is useful information, but it requires knowledge of important data from the company's sales and costs. We'll go over what a gross profit ratio is, why it's significant, and how to calculate it in this article.
What is the Gross Profit Ratio?
The gross profit ratio (GP ratio) is a financial ratio that divides a company's gross profit by total net sales to determine its performance and efficiency. By multiplying the result by 100, the gross profit ratio can also be stated in percentage form, which will be called gross profit percentage or gross profit margin.
The gross profit of a company is determined by calculating total sales over a period of time and subtracting the total costs of labor and materials required to generate the goods and services that the company is selling. The net sales number for a company represents all of its gross sales during a certain period, as well as income from other sources such as interest, rented properties, royalties, and other sources, less returns, allowances, and discounts.
Why Is The Gross Profit Ratio Important?
The key benefit of the gross profit ratio is that it is a precise indicator of how efficiently a company sells its goods and services. This will give the company's management and potential investors an idea of how successfully the company manages to streamline its processes, keep expenses low, and make the most profit feasible.
The following are some of the primary reasons why the gross profit ratio is important:
1. It informs management of the amount of funds available for reinvestment
Knowing how much of your income remains after all expenses have been deducted is important because it informs management about how much of the money they can reinvest in the business. A high gross profit ratio allows those in charge of the firm's growth to devote resources to raising brand awareness, recruiting more employees, and other ways to improve the company.
2. It has the potential to attract or discourage investors
A high gross profit ratio will appeal to potential investors because it can be seen as a clear indication that the investment will pay off in a reasonably short period of time. A low or negative gross profit ratio indicates that, despite significant income, the company will need to restructure its spending.
3. It can provide a business with the flexibility it needs
A low gross profit ratio, regardless of a company's sales, suggests that there isn't much room for errors in its operations. Any change in the company's operations, production costs, material costs, or markets it serves has the potential to turn a profitable business into a losing one.
A high gross profit ratio, on the other hand, allows the company to remain profitable despite these changes, allowing management to experiment and innovate more freely.
4. It is typically difficult to change
Increasing a business's gross profit margin is normally a difficult task that necessitates a comprehensive redesign of the company's operations. As a result, establishing a good gross profit-to-total sales ratio as soon as possible might be important to the company's future success.
Gross Profit Ratio Formula
Gross profit divided by net sales x 100 is the formula for calculating the gross profit ratio.
The gross profit is calculated by subtracting the cost of goods sold from total net sales. The cost of goods sold is calculated by adding the opening stock, total purchases, and direct expenses, if any, and then subtracting the closing stock.
The net sales figure is obtained by adding cash and credit sales and deducting sales returns.
How to Calculate Gross Profit Ratio
When calculating the gross profit ratio, follow these steps:
1. Gather all the required metrics
Calculating a company's gross profit ratio over time necessitates familiarity with key financial metrics such as:
- The opening stock of the calculated period
- The total purchases
- The total direct expenses, if any
- The closing stock at the end of the calculated period
- Cash sales
- Credit sales
- Sales returns
2. Calculate net sales and gross profit
The two elements of the gross profit ratio must be determined after the appropriate metrics have been gathered. You must determine the net sales by adding the cash and credit sales and deducting the sales returns after determining the cost of goods sold by adding the opening stock, purchases, and expenses and then deducting the closing stock. Finally, deduct the cost of goods sold from the net sales figure to arrive at gross profit.
3. Apply the gross profit ratio formula
By dividing gross profit by net sales, the gross profit ratio is determined. The result is frequently multiplied by 100 so that it can be stated as a percentage, which makes it easier to understand and compare. You can then figure out what percentage of the company's revenue is profit.
Gross Profit Ratio Examples
Here are some gross profit ratio examples:
Example 1
Flagtastic, a company that designs and manufactures flags, with a total annual sales of $100,000. Their cost of goods sold was $43,000 in the same year. This indicates that the gross profit of the company may be computed by subtracting $43,000 from $100,000, yielding a profit of $57,000.
We can calculate the gross profit ratio by dividing the gross profit by the total sales amount now that we know the two elements of the gross profit ratio formula.
$57,000/$100,000=0.57
At this point, we can then express it as a percentage by multiplying it by 100.
0.57*100=57
Therefore, the company has a gross profit margin of 57% and a gross profit ratio of 0.43
Example 2
Fedora is a furniture company that generates a net sales of $250,000 in a calendar year. Their opening stock was worth $112,000 at the start of the year, and they spent $54,000 on raw materials during the course of the year. In addition, they spent $9,000.00 on different expenses. They still had $23,000 worth of items in stock at the end of the year.
From the question above, the first step is calculating the cost of goods sold.
$112,000+$54,000+$9,000-$23,000=$152,000
You can calculate the Gross profit by subtracting the cost of goods sold from the total net sales.
$250,000-$152,000= $98,000
Finally, we may use its formula to calculate the gross profit ratio.
$98,000/$250,000=0.39
0.39*100= 39
The company has a gross profit margin of 39 percent and a gross profit ratio of 0.39
