Definition: Gross profit ratio is a calculation that determines the correlation between a company’s gross profit margin and the net sales (gross sells net of credits and discounts issued).
What Does Gross Profit Ratio Mean?
What is the definition of gross profit ratio? The GPR is a calculation that returns a value representing the percentage of profit earned on the net sales of an organization. The net sales value of an organization is calculated by reducing the gross sales amount by any credits issued for product returns, discounts, or rebate programs. The costs applied to the net sales to determine the gross profit is achieved by calculating the total direct cost of sales (inventory change + direct costs). Simply put, the ratio indicates the true profitability of a sales transaction after the impact of sale credits are applied. The gross profit ratio formula is calculated like this:
((Net Sales – Cost of Goods Sold) / Net Sales)) x 100
The GPR is leveraged by users of financial statements to evaluate the true profitability of an organization’s sales. In many cases, this ratio is used for comparison purposes to competitor’s financial statements, as well as applicable industry trends. The ratio is a great indicator of the organizations ability to absorb non-product related operational expenses. The larger the GPR, the more gross profit the organization has to fund operations.
Let’s say you receive the previous two years of financial data associated with a company, and you’d like to calculate the GPR to determine whether management is making a good business decision to invest in the business and increase operational expenses in Year 2. Here’s the data received:
|Year 1||Year 2|
|Cost of Sales (Inventory Change + Direct Costs)||$-500,000||$-645,000|
Leveraging the formula outlined above, the Year 1 GPR is 41%, or $350,000 based on the following:
($850,000 Net Sales – $500,000 Cost) ÷ $850,000 Net Sales = 41%
The GPR for Year 2 is 28%, or $255,000 based on the following:
($900,000 Net Sales – $645,000 Cost) ÷ $900,000 Net Sales = 28%
Based on this information, you may derive that the company was less profitable in Year 2, and although the company grew sales by 25%, the gross profit to fuel operations was actually less than Year 1 by $95,000. This reduction in GPR from Year 1 to Year 2 would indicate that it may not be the best idea for management to increase operational expenses within the company during Year 2.
Define Gross Profit Ratio: the correlation between gross profit and net sales.