Gross Profit (GP) Ratio or Gross Profit Margin – Definition and Explanation:
Gross profit ratio (GP ratio or gross profit margin) tells us how much (as a percentage) of the firm’s sales revenue is made up of gross profits. This is found by dividing the gross profit by the value of net sales. For the calculation of this ratio both figures being taken from the trading section of income statement.
The gross profit ratio evaluates the trading performance of a business on account of selling and purchasing/manufacturing activities. The ratio signifies (in percentage terms) the profit business is able to earn by selling goods a a higher price over ther cost of these goods. This profit is then used to meet operating and financial expenses.
Sometimes gross profit is also related to cost of sales; this relationship is known as markup.
Note: It would be very misleading to compare the gross profit margin of two businesses operating in entirely different industry (e.g. a jeweler and a super market) but a comparison between two business in the same line of trade should be meaningful and might throw some light on the pricing policies adopted by each of the business concerned.
Click on Analysis of Financial Statement of a Business to read the solved example of GP ratio.
Which Trend is Better:
Higher gross profit ratio is undoubtedly preferred but some times higher margins result in lower sales volume which may not be taken as a positive sign for a business aiming at increased market share.
Use of Gross Profit Ratio:
Gross profit ratio may be improved by reducing cost of purchases through buying in large quantities or from a new supplier with better terms. This improvement may also be possible by increasing the sale prices, or more sales of higher margin items.