Gross Profit Ratio – Definition
Gross profit ratio (or gross profit margin) shows the gross profit as a percentage of net sales. The ratio provides a pointer of the company’s pricing policy. Certain businesses aim at a faster turnover through lower prices. Such businesses would have a lower gross profit percentage but a larger volume of sales. Some businesses that have higher fixed (or indirect costs) need to have a greater gross profit margin to cover these costs. Such businesses aim to cover their fixed costs and have a reasonable return on equity through larger gross profit margin from a smaller sales base.
Net Profit to Gross profit Ratio
Net profit to gross profit ratio (NP to GP ratio) is an extension of the net profit ratio. If we deduct indirect expenses from the amount of gross profit, we arrive at net profit. In other words, gross profit is the sum of indirect expenses and net profit. By expressing net profit (or indirect expenses) as a percentage of gross profit, we find out as to what portion of gross profit is eaten by indirect expenses and what portion is left as net profit.
These two items (net profit and indirect expenses) are the main consideration behind a company’s pricing policy. If net profit as a percentage of gross profit is small, it may indicate any of the following three things:
- The prices are driving the customers away;
- Expenses are too high in relation to the volume of business handled; or
- gross profit margin is inadequate.
Gross Profit Ratio Formula:
- Gross profit = Net sales – Cost of goods sold (COGS); and
- Net sales = Gross sales – Sales returns or returns inwards
Both the components of the formula (i.e., gross profit and net sales) are usually available from trading and profit and loss account or income statement of the company.
Calculate and interpret the gross profit ratio from the following information of John Trading Concern for the year 2016.
Sales returns: $50,000
Opening stock: $570,000
Closing stock: $630,000
(1). Calculation of gross profit ratio:
The two figures that we need to calculate the gross profit ratio are the net sales and the gross profit. The data of the John Trading Concern does not show these figures. Therefore, we need to find out the net sales and gross profit of John Trading Concern before computing the G.P Ratio. It may be done as follows:
Net sales = Gross sales – sales returns
= $4,850,000 – $50,000
Gross profit = Sales – Cost of sales
= $4,800,000 – $3,600,000*
*Cost of sales = Opening stock + Purchases – Closing stock
= $570,000 + $3,660,000 – $630,000
Now we have found both net sales and gross profit figures and can easily compute the G.P Ratio of the John Trading Concern.
Gross profit ratio = (1,200,000/4,800,000) × 100
(2). Interpretation of gross profit ratio:
The John Trading Concern has a gross profit ratio of 25% during the period. While this ratio may appear to be reasonable for a trading concern, it is impossible to pass a judgment on adequacy or otherwise of this percentage unless we know the G.P Ratio of other businesses in the same field, or of this company over past years, or the target G.P Ratio set by the company’s budget for the year. This is a very important aspect of using ratios as a tool of evaluation. A ratio in itself cannot be of much help unless it is compared with a similar ratio obtained from a related source.