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Each company uses a range of metrics to analyse its financial statements. It helps them determine their profitability and position in the market. There are numerous tools and methods you can use to analyse a company’s financial statements, among which the gross profit ratio is a widely used one.
While choosing a company for investment, you can use this metric to determine its profitability and financial position. In addition, it will help you determine whether or not it is suitable for your portfolio.
The gross profit ratio is a financial metric that helps a company assess its profitability. You can use it to determine the amount of profit a business makes by selling its goods and services after subtracting its direct costs.
To state simply, this metric helps you determine how efficiently a company’s production process uses its raw materials and labour resources.
The gross profit ratio is the value derived by subtracting the net sales of a company from the cost of goods sold (COGS) and dividing it by the net sales. Here is the gross profit ratio formula:
Gross Profit Ratio = (Net Sales – COGS) / Net Sales
The cost of goods sold (COGS) is the direct costs incurred in a firm’s production process. It includes labour and material costs. These expenses tend to vary across different companies and industries.
However, do note that other fixed costs like marketing and administrative expenses and indirect costs do not constitute the cost of goods sold by an establishment.
The net sales in this formula are different from the total sales of a company. A firm determines it by subtracting allowances, discounts and any sales returns from its total sales.
Let’s take an example for better understanding.
Suppose, Reliance has a cost of goods sold worth Rs.45 lakh and net sales of Rs.85 lakh. Now, this is how you can calculate the gross profit ratio.
Gross profit ratio of the company = (85,00,000 – 45,00,000) / 85,00,000
= 0.4705 or 47.05%
Thus, the gross profit margin ratio of Reliance is 0.4705 or 47.05%.
Apart from using this formula, you can also use a gross profit ratio calculator to determine a company’s profitability ratio.
Remember, the direct costs of a company are always variable. They change with their production quantity. Thus, you will find this profitability ratio changing when you look at various companies and industries.
Determining the gross profit ratio helps both companies and investors. Let’s take a look at how companies can benefit from knowing their gross profit ratio:
A high-profit margin for a company indicates better efficiency. It also gives company owners a clear idea of how their production expenses are affecting the firm’s revenue. All in all, it tells how good a company is being managed by its owners.
On the other hand, a low-profit margin ratio of a company indicates a company’s inefficient production process. It may be the result of poor pricing, a fall in sales price, high production costs, etc. Businesses can use the gross profit margin ratio to detect and resolve such problems. Then, they can respond to the situation by evaluating their business strategy, cutting costs, altering cash flow projections, etc.
This ratio serves as a benchmark for company owners to compare their performance with that of their competitors. For example, if they notice a steady rise in their profit margins, it may signify that the company has few competitors in the market.
Alternatively, if there is a steady fall in the gross profit ratio, it may denote a highly competitive market scenario. There may be a slight difference between competing goods and services available in the market.
Thus, with the help of this ratio, businesses can set competitive prices while ensuring that they will still reap profits.
Companies can use their gross profit ratio to determine how much capital they have remaining after the settlement of all their expenses. If it has a high-profit ratio, the management can reinvest the surplus capital to grow its business. It can do so by increasing brand awareness and value, hiring new employees, etc.
A company’s gross profit margin ratio can help it to make flexible decisions. If it has a high profitability ratio, the business can keep earning profits and remain valuable to its investors.
On the other hand, if the company has a low gross profit ratio, despite having high revenue, it indicates that it cannot afford to commit any errors in its operations. Even a slight change in its strategy relating to its operations, target markets, production and material costs, etc., has a huge potential to impact its profitability. It can turn a company losing its value into a profitable one.
Apart from all these benefits, the gross profit margin ratio helps firms recognise areas of improvement. For example, if a company has a higher profitability margin, its management can use it to reduce the cost of goods sold. Furthermore, they can also shift the sales strategy for other products that the firm deals in.
As an investor, a company’s gross profit ratio can serve as a make-or-break factor. When you notice that a company has a high gross profit ratio, it becomes an attractive investment opportunity. It signifies that the business’s investments will pay off soon.
Alternatively, if a company has a low gross profit margin ratio, it signifies that the firm may be generating revenue; however, it needs proper restructuring in order to decrease its spending.
Now that you know what is gross profit ratio, you can use it to find companies with good profit potential. However, please keep in mind that it is only a passive indicator of a business’s overall status. Furthermore, this ratio does not take into account those expenses that are charged in a firm’s profit and loss account.