The Gross Profit Ratio is probably one of the most commonly used financial and accounting metric. Along with the gross profit margin, it can help us understand not only how well a company is doing in term of generating sales but also controlling its cost.
Apart from the fact that gross profit is widely used, it’s also a very straightforward figure or ratio to calculate since the only numbers that are used are the revenue and the cost of sales, both obtained from the income statement.
Gross Profit and Margin Formula
As explained above, the gross profit is calculated by deducting the cost of sales from the revenue or the sales that a company has generated in a financial year. In other words, the gross profit formula can be calculated as:
Gross Profit= Revenue – Sales
However, the gross profit margin is presented as a percentage and it tries to add comparability and correct for the fact that different companies have different sales figures. A comparison of the gross profit and the gross profit margin is provided below but for now, the gross profit margin formula is:
Gross Profit Margin= (Revenue-Cost of Sales)/(Revenue) * 100%
We will use an example to help you understand how the gross profit and the gross profit margin are calculated and how you can analyze and interpret the results.
Let’s assume that we have two companies. Company A is bigger than Company B. In particular, Company A was able to generate $20m of sales and the cost of sales were $15m. On the other hand, Company B was able to generate $5 of sales and the cost of sales were $2.5m.
Using the formulas above, for company A the gross profit and the gross profit margin are:
Gross Profit= $20-$15=$5m
Gross Profit Margin= ((20-15)/20)*100%=25%
For company B, the results are:
Gross Profit= $5m-$2.5=$2.5
Gross Profit Margin= (($5m-$2.5)/$5)*100%=50%
What the above example shows, is that the gross profit can be used to help us understand how a company is doing in terms of revenue generation over time and within the same industry. However, it has a weak point when used for companies of different sizes. For this reason, it’s a good idea to use both the gross profit and the gross profit margin. For the example above, company B has lower gross profit but higher margin. In other words, while Company B is smaller, it performed better in terms of cost control.
So we established that to get more information, we should be using both financial ratios. But what information do we get by calculating the gross profit and the gross profit margin? An important note to add here is that which we made in our net profit ratio article; and that is the benefits of cross-sectional and longitudinal analysis.
As explained above, the information you will get is pretty much the same for both ratios. However, the margin tries to correct for the “size issue”. In other words, you can analyze these two financial ratios and understand:
1. Whether a company is having steady revenue growth. In particular, by calculating these two ratios for more than one year (maybe a five-year horizon will enhance your analysis) and especially by diving into the different revenue streams (such as clothes department, shoes department etc.), you will be able to understand if the company is growing and if the sales are increasing.
2.Apart from the sales increase, you will also be able to understand if the company is able to control its costs and increase profitability. Increasing sales is definitely something that all companies want. On the other hand, if you increase sales by 10% and cost of sales increase by 20%, then the net result is definitely not good.
3.We talked about the sales increase but you can actually get more information from these two metrics. In particular, the revenue sales depends on the price and the volume. So if you know that the prices are stable (let’s say for example that the industry averages are relatively stable) and you can see that a company has increased its gross profit, then you can assume that it’s attributable to increased volume. This is particularly good because it can mean that the company is able to expand its client base and rely less on specific customers.
4.Similarly, the gross profit and the gross profit margin can help you understand whether specific costs are constantly increasing, pushing the company’s margins lower and lower. To be fair, you will need more information than just that cost of sales figure; large companies usually include an analysis of the cost of sales in the notes. Similarly, if you are calculating these two figures to for internal analysis (i.e for your company), you probably have access to such information.
Gross Profit Calculator
There first calculator will help you get the gross profit.
Gross Profit Ratio Calculator
Finally, this calculator will help you derive the gross profit margin. Both calculators should be self explanatory but if you have any questions, feel free to leave a comment.