What is Gross Profit Ratio? Why is it so Important?

What is the Gross Profit Ratio?

Gross profit ratio is a ratio or metric that helps in determining the efficiency and performance of a company. It is computed by dividing the gross profit of a company by its total net sales. Moreover, the GP ratio can also be obtained in a percentage firm by multiplying the above result by 100. When done so, it is regarded as the gross profit margin or gross profit percentage. 

To calculate the gross profit ratio of a company, first its total sales are determined over a certain period and then the total material and labor cost is deducted to get the ratio.

Why is Gross Profit Ratio Important for Investors ?

Following are the reasons that shows why gross profit ratio is an important factor for the business as well as investors:

1.It Allows Businesses to Determine How Much They Can Reinvest 

By having the knowledge of how much capital they are left with after settling all their expenses, businesses or companies can determine how much they can reinvest. Generally, a high gross profit ratio allows the management responsible for the growth of the organization to provide enough resources for hiring new employees, increasing brand value and awareness, and many other ways to grow the company. 

2. It Can be a Make or Break Factor for Investors 

Note that a higher value of gross profit ratio makes a company or business very attractive in the eyes of investors. The reason behind this is simple, it shows investors that the investments made by the company will pay off soon. On the other hand, a low GP ratio indicates that the company may be generating an impressive revenue, it needs to lower its spending by proper restructuring. 

3. It Offers Great Flexibility to the Companies 

Regardless of a company's high revenue, a low gross profit ratio hints that there is no scope for errors in its operations. In other words, even the slightest change in the operations, material costs, production costs, or target markets of a company can easily turn a profitable company into one that is losing its value. However, a higher GP ratio allows the company to remain valuable and profitable regardless of the changes we have just discussed. It offers great flexibility to the management to innovate and experiment for the betterment of the company. 

Gross Profit Ratio Formula

The gross profit margin is basically the percentage of capital that remains after deducting all the expenses. Below is the formula for GP ratio:

Gross Profit Margin = {Net Sales - Total Cost of Goods Sold} / Net Sales

Here, 

Net Sales stands for discounts and deducting sales returns from the total sales made by an organization. It is used because it gives more accurate information as compared to total sales. 

Cost of Goods Sold – It is the direct cost involved in operations like direct labor and materials. These are variable costs that change from company to company and industry to industry. Moreover, while calculating gross profit ratio, other fixed and indirect costs like marketing expenses, administrative expenses are not included in the Cost of Goods Sold. 

How to Calculate Gross Profit Ratio?

Let's learn how to calculate the gross profit ratio with the help of an example. 

Suppose a company has net sales of Rs. 50 lakh and cost of goods sold is Rs. 25 lakh. Now, calculating the gross profit ratio, we get:

Gross Profit Ratio = (50,00,000 – 25,00,000)/ 50,00,000

= 0.5 or 50%

Therefore, the gross profit ratio of the company is 50%.

Bottom Line

The gross profit ratio plays an important role in determining the efficiency and management of a company. It also shows how much more a company needs for covering its total operational costs. We hope it helps.