Analysing any financial ratio is crucial for the fundamental analysis of a company. They show different aspects of an organisation’s profitability and cost-efficiency. There are different types of ratios that help measure the company’s profitability against revenue over time. They are expressed in the form of percentage. In this article, we will discuss the gross profit ratio along with its calculation and interpretation.
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What is Gross Profit Ratio?
Gross Profit Margin Ratio, sometimes also referred to as gross margin, is a type of profitability ratio. It helps to measure how much profit a company makes from the sale of goods and services after deducting the direct costs. In simple words, it is a simple metric to measure the company’s profitability. Also, it helps to evaluate how efficiently the company is using its labour and raw materials during the production process.
The gross profit is calculated in a company’s income statement after deducting the cost of goods sold from the total sales. The cost of goods sold considers only the company’s direct costs, not indirect costs. The direct costs are variable as they change with the quantity of production. Examples of direct costs are direct labour and direct materials.
The gross profit margin ratio may vary for the company and industry. The higher the profit margin indicates more efficiency of the company. Also, this ratio gives owners a picture of how production costs affect their revenue. If the gross margin depreciates, they may revisit their strategy, change cash flow projections, change pricing, cut costs, cheaper raw materials, etc.
Gross Profit Ratio Formula
The gross profit margin is the percentage of revenue that remains after the cost of goods sold. The following is the formula to calculate –
Gross Profit Margin = (Net Sales – Cost of Goods Sold)/ Net Sales
- Net Sales – is deducting any sales returns, discounts or allowances from the total sales. Net sales give more accurate information than total sales.
- Cost of Goods Sold (COGS) – is the direct costs during the production process like the direct materials and direct labour. These costs may vary depending on the company and industry. Also, indirect costs and other fixed costs like administrative expenses, marketing expenses are not a part of in the COGS.
Let’s assume that a company ABC has Rs. 75 lakhs net sales and the cost of goods sold per the income statement is Rs. 35 lakhs. What is the gross profit margin?
Gross Profit Ratio = (75,00,000 – 35,00,000)/ 75,00,000
= 0.5333 or 53.33%
Therefore, the company earned 53% gross profit from its total sales before. This is further used to cover the operating expenses and other costs.
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Interpretation and Importance of Gross Profit Margin Ratio
Gross Profit Margin Ratio is a yardstick for measuring how a company makes a profit from its products and services. The following is the interpretation of this ratio.
Efficiency in Production Process
This ratio helps measure the company’s efficiency to arrive at a profit after the production and sales process. The company aims to generate a higher gross profit margin. A higher ratio indicates that the company is producing more efficiently. In simple words, it indicates that the company has efficient management, low-cost production, and increased sales price. However, the stock evaluation is not considered as this does not indicate the efficiency in running the business. Any significant changes in this ratio can sometimes indicate poor company management. However, there can be other reasons for fluctuations like temporary manufacturing issues resulting in lower product quality.
Conversely, a low ratio indicates that the company is not producing efficiently. It requires careful, in-depth analysis. Some of the reasons can be higher cost of production, a decline in sales price, poor pricing strategy or any change in sales mix. Thus, the company must watch out and avoid a lower ratio situation as it can lead to losses.
Importance of Gross Profit Margin Ratio
The following is the importance of gross profit margin ratio –
- A gross profit margin ratio can compare companies with sales revenues.
- It is a straightforward financial metric for analysis on sales revenue, as it eliminates the other corporate expenses.
- This ratio can indicate how well the company is being managed.
- With the help of this ratio, companies can set the pricing at a competitive level ensuring the products are still profitable.
- It provides a benchmark for comparing a company’s performance with competitors. A steady decrease in profit margins can indicate a highly competitive market with a slight difference between competing goods and services. In contrast, a steady increase in profit margins may indicate that the company has fewer competitors or can differentiate its product among others.
- Lastly, this ratio can be helpful to highlight the areas of improvement. For instance, if one product has a higher gross profit margin, the management can use this as an opportunity to reduce COGS or shift the sales strategy for other products.
Thus, a gross profit margin plays a vital role in understanding the company’s management and shows how much more the company has to cover operating financing and other costs. Also, it is essential to keep this ratio stable, and any significant change requires action immediately.