A company has to earn profits to maximize shareholder’s value. In order to arrive at the net profitability of the company, various direct and indirect expenses are required to be deducted from all the incomes of the company.

A company earns revenue by making sales to its customers. A company’s profitability position is generally measured by two important ratios which are gross profit ratio and net profit ratio. Gross profit ratio is also known as gross margin.

Basics Of Gross Profit Ratio

Gross profit ratio is expressed in a percentage form. Gross profit ratio is calculated by dividing the amount of net sales by the amount of gross profits and multiplying the resultant figure with 100. Amount of net sales is arrived at after deducting any amount of sales returns from the amount of gross sales.

Gross profit is arrived at after deducting the value of opening stock, purchases and direct expenses from the value of net sales and closing stock. For Instance, a company’s net sales is $ 1, 50,000 and the value of its closing stock is $ 50,000. Further, company had an opening stock of $ 20,000 and made purchases for an amount of $ 1, 00,000.

Company’s gross profit in this case would be $ 80,000 and its gross profit ratio would be 53.33% ($ 80,000 (Gross Profit)/$ 1, 50, 000 (Net Sales)). Figures for calculating gross profit are available in the trading and profit and loss of a company.

Analysis Of Gross Profit Ratio

A lower amount of gross profit in relation to total sales may indicate that the company is not efficient in controlling its direct costs such as the cost of raw material and labor required for production purposes. Ineffective control over the production process may result in wastage of raw material or excess labor cost which may reduce the level of gross profit for the company.

A company should keep a constant check on the gross profit ratio, as a significant decline in this ratio may indicate stock theft, high cost of raw material, excess sales returns and so on. A high gross profit ratio indicates the amount of money that would be available with the company to pay for its operating and fixed expenses. A high gross profit ratio indicates the efficiency with which a company is able to convert its raw material into actual sales.

While analyzing gross profit ratio, it is very important to understand the nature of the industry in which a company operates. It is quite possible that a particular industry may be characterized by a low gross profit ratio on account of slow conversion of raw material into sales. Gross profit ratio should not be considered as the only measure for evaluating a company’s financial status and performance.

It is quite possible that a company may have substantial control over its indirect expenses which may ultimately result in a higher net income for the company. However, with the help of gross profit ratio, a company can identify areas for improvement which have a direct bearing on its profit margin.

For Instance, by making a comparison with previous year’s gross profit ratio, a company may find excessive labor costs as a reason for decline in its profit margin. A company can take corrective measures to ensure that labor costs are kept at an optimum level in the coming year which may help the company to increase its profit margin.

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