What is Gross Profit Ratio? Meaning, Formula & Calculator

Now, let's look into detail the meaning, formula, examples and interpretation of Gross Profit Ratio.

In many ways, profits measure the worth of a company in a trivial sense. The main purpose of any business is adding value, but value can be intangible, and to paraphrase John Von Neumann, the subject matter of economic theory lies in quantification of mechanism of prices, production, earning and spending. So, in many ways, profits, or the measurement thereof provides a sort of barometer for performance. But first, let’s get into why using financial ratios is a good idea at all.

Financial Ratios: Need & Importance

The problem with numbers, however, is the fact that by themselves, they don’t mean anything. For example, consider this. District A has 500 people, and about 450 personal vehicles. One inference that you can draw from this is that A has a relatively good standard of living, and is probably in a country with prosperity. But that still doesn’t give you how many people actually use the vehicles, what kind of resources they utilize, and so on.

For instance, out of 450 vehicles, 300 are bi-cycles, about a 100 motor bikes and 50 cars, and out of those 150 motorized vehicles, only 10 are used on a regular bases. Did that change your image of A from a well to do neighborhood to a district in a country which probably has oil shortage?

The same way, profits by themselves mean nothing except telling you this is the amount of surplus that was earned. But when you compare it with previous year’s profit/loss, you get the idea of how much the business has grown, when you compare it with sales figures, you get how much margin does the business earn, and how well are its expenses handled. That is exactly what ratios do, they serve as sort of comparison giving a figure that is not absolute, but relative to something else.

One such ratio, and probably the most simplest of all, is Gross Profit Ratio. And, that's what we'll be discussing in detail here.

What is Gross Profit Ratio? Meaning

Gross Profit takes into account two things. Gross Profit of a business, and sales. Gross Profit ratio is basically gross profit represented as a percentage of sales. The formula looks a bit like this.

Gross Profit Ratio Formula

A simple and easy to grasp GP ratio formula:

Gross Profit Ratio = ( Gross Profit / Net Sales ) * 100

Here, Gross Profit = Net Sales - Cost of Goods Sold

where Net Sales = Sales - Return Inwards and

Cost of Goods Sold = Opening Stock + Purchases - Closing Stock + Direct Expenses Incurred

Those murky waters comfortable for you, lad? Let’s dive a little deeper.

To understand the importance, or even the why of GPR, we look at what the ratio represents, starting with gross profit first.

Basically, when you break down any business activity anywhere in the universe, a business is basically two things, there are costs, and there is revenue. Revenue is simple, it is money coming in. Costs, however, can be further divided into two types.

When you run a business, you incur expenses to make a product/service in the first place, which is obviously essential to the business. These are known as manufacturing costs, or cost of goods sold, which is just basically another way of saying “The goods that were sold, reflected in sales, this is what it cost to make those goods.”

Then there are costs you incur to get the product to your customers, expenses like cost of telling people you make cool stuff (advertising costs), cost of hiring people to design more cool stuff, maintain books or cost of rent of the place where you make cool stuff (administration costs), costs of actually selling your cool stuff i.e. getting it to different places (selling and distribution costs), etc.

For the calculation of GP ratio, however, we focus on the first set of costs, that is the costs that were incurred to bring the raw material in and convert them into finished goods. We compare these costs with Sales in an indirect manner. Consider this example.

Gross Profit Ratio Example Explained:

A company, Sub-Zero ltd. has inventory of raw material (previous year’s closing stock/ this year’s opening stock) worth of Rs 2,00,000 and it purchased raw material worth Rs 5,00,000. At the end of the year, it had a closing inventory of Rs. 40,000. For the same year, the company sold goods worth Rs. 10,00,000.

During the year, the company returned raw material worth Rs. 50,000 to its supplier, Scorpion ltd, because the goods were defective. Also, goods sold, worth Rs. 70,000 were returned back to the company because they were defective as well.

Calculation of Gross Profit Ratio

For calculation of GP ratio here, we first calculate the Gross profit.

Gross Profit = Net Sales - COGS

Gross Profit = (Sales – Sales Return) – (Opening Stock + Purchases – Closing Stock – Purchase Returns)

Gross Profit = (10,00,000 – 70,000) – (2,00,000 + 5,00,000 – 40,000 – 50,000)

Gross Profit = Rs 3,20,000

Now, we compare this profit to Net Sales.

Gross Profit Ratio = ( Gross Profit / Net Sales ) * 100

Gross Profit Ratio = ( 3,20,000 / 9,30,000 ) * 100

Gross Profit Ratio = 34.41 %

How is Gross Profit Ratio Used?

Analyzing the aforementioned example, the ratio there basically means that for every Rs. 100 of sales, 100 because it is in percentage form, we get a profit of Rs. 34.41. Or you could look at it the other way, which probably is more useful. For every Rs. 100 of sales, Sub-Zero ltd incurs a cost of Rs. 65.59 (100 – 34.41).

Both of these perspectives have applications. The most basic use is as an analytical term for sales on a purely quantitative co-correlation basis, for example if Sub-Zero were to infuse more capital in production (taking demand as a constant, obviously), then for every Rs. 65.59 of incurred costs, you would obtain sales of Rs. 100 (or for every Rs. 100 increase in sales, the profit increases by Rs.34.41).

But here’s the thing, you can’t exactly take demand as constant in real life, because there are a ton of other factors involved. That was the textbook-mentioned use, anyway, let’s get into how you can actually use GP ratio, in real life.

How can Gross Profit Ratio be used in Real Life?

As mentioned earlier, even ratios don’t mean anything by themselves. But, from an analytical perspective, there can also be comparison made for a company over a period of time to see how the company’s profit margin has reacted over the years with increase and decrease of sales, which can be a very insightful tool for a company’s production efficiency, and to some extent lower management's efficiency too, a display of how they have managed to control costs.

Another way GP ratio can be used is by comparing it to Net Profit ratio, which instead of just manufacturing cost like GP ratio, accounts for all the costs and compares that with sales, so there’s a common unit of measurement.

Note: While GP ratio will always be bigger than Net Profit ratio, how much gap is there between the two ratios can tell you a lot about company’s managerial efficiency and cost distribution.

For example, in the above scenario, if the Net Profit ratio is, say 4.41%, that means while the company is earning about Rs. 34.41 for every Rs. 100 of sales, it is bearing Rs. 30 in just advertising and administration costs, bringing the profit margin so down that unless it is a business on a huge scale, growth is unfeasible unless the costs are cut down. Again, there could be various scenarios.

If you want to make things fun, however, think of a scenario where Net Profit ratio can be greater than Gross Profit ratio, and comment below! (Hint: The answer doesn’t lie in costs, it lies in revenue.)

Gross Profit Ratio: Limitations

Like any analytical tool, used by itself, GP ratio does have some limitations.

First, while it gives an idea of the company’s costs compared to sales, it only looks at manufacturing costs, which is basically saying it doesn’t factor in other costs. This could very well mean the difference between profit and loss.

Secondly, it can get a little trick just analysing manufacturing costs. For example, say the company under consideration is an application like Paytm or Netflix, which might not even have manufacturing costs. GP ratio is useless there. (Of course, for Netflix, you may take the costs of licensing deals with studios for movies as manufacturing costs, or perhaps costs of server space, but you get the idea right?)

Gross Profit Ratio: Final Interpretation

Gross Profit ratio is probably one of the simplest ratios out there, and yet at the same time when used properly can be very effective. But don’t let your ratio education stop here, we have a ton of other useful important financial ratios and intuitive stuff, check them out!

That was all about Gross Profit ratio and its interpretation. If you have any additional information to add here, do let us know. And, yes don't forget to try our FREE Gross Profit Calculator above and share your feedback.