Gross Profit Ratio: Are You Really Making a Profit?

gross profit ratioIf you’re thinking about starting a business a good thing to do is create a business plan. This is a comprehensive layout of everything that is required to make your business successful. You’ll need to write up very detailed explanation of what you are trying to do, why and how you are going to do it. Part of this plan is to write out every minute detail of your financial plan, ranging from personal assets, investors, projected income and expenses. One of the figures that is crucial to understanding the potential of your business is the gross profit ratio. The gross profit ratio tells you how much money you are making on a product after you deduct its expense from your asking price. Once you calculate your gross profit ratio you will discover what you’re profit margin is – and if you have one at all. Accounting knowledge is vital to running a business so don’t get left behind, learn all about it in Financial Accounting.

The gross profit ratio (GP ratio) calculates the relationship between your gross profit and total net sales revenue. This formula allows you to evaluate your profitability ratio and analyze the health and performance of your business. The GP Ratio isn’t the only important ratio to evaluate business performance, either. In Accounting Ratios you can learn what the other ones are.

The equation to calculate your gross profit ratio is:

Gross profit ratio =     gross profit/net sales

If you need your gross profit ratio stated as a percentage, then you will just multiply the gross profit ratio found above by 100. Get up to speed on finances and understand business in Learn Accounting.

What are net sales?

When you are a business owner there seems to always be a lot of number crunching. There’s the net sales, gross sales, gross profit, deductions and expenses to account for. The net sales is a term you want to get familiar with because it paints a more accurate picture of the actual sales generated by your business. Consider this, you have a 30-day return policy instated in your store. You ran the numbers in the middle of the month to see how business is doing and found that your total sales summed $6,000. However, one week later a customer returns an item worth $1,000. Due to your policy, you except the item and now have $1,000 less than you did a week ago. The net sales is the total amount of money left after you deduct all discounts, damaged goods and returns from the total gross sales. Usually the net sales are reported on your monthly income statements.

What is a gross profit?

Gross profit is determined by your net sales minus the total cost of goods sold. So you know that you have a total of $5,000 for the month of April in sales, but you had to spend $3,000 to purchase the goods that you sold. This means your gross profit for April is actually only $2,000. It’s easy to get carried away when you see large sales numbers and you forget that you invested X amount of money to make those sales possible.

GP Ratio Example

Using the figures above, let’s calculate the GP ratio for this business in the month of April.

Total Sales: $6,000

Net Sales: $5,000

Gross Profit: $2,000

Using the formula for the GP ratio, we take the gross profit and divide it by the net sales to get a ratio.

Equation:

$2,000/$5,000 = .40 or 40%

What this means is, you can reduce the asking price of your goods by 40% without losing any money. However, this wouldn’t be ideal as you would only be breaking even, but if things get really bad, you know you have some wiggle room. It’s important to remember that your gross profit is not only money you are putting in your pocket, but its money that needs to cover the rest of your business expenses as well. This number begins to decrease as you subtract operational expenses, salaries and emergencies that may arise. As an entrepreneur you’ll need to be prepared for just about everything. Don’t just hire someone to do all of the book keeping for you. Knowing your way around a financial plan and income statement is only going to benefit you. Learn small business financing from A to Z in this course taught by a CFO.