Gross profit margin is the ratio of gross profit to the net sales. It is known by different names like gross profit ratio or gross margin. It is a significant ratio as it deals with a profit which is the final destination of all the strategies and decisions in a business. Gross profit margin is the first benchmark for business. Without doing well at this benchmark, there is no point looking at any other thing.
Gross profit margin is one of the profitability ratios and an analytic for financial analysis. This ratio speaks of the adequacy of the profits per dollar of sales and the growth/decline in performance compared to the previous period or the industry. Adequacy of profit is defined in terms of covering the operating expenses and a satisfactory return to the shareholders.
Operating expenses may include the selling and distribution expenses, administration, financing charges, taxes, etc.
Gross margin is the margin of profit left after deducting manufacturing or trading expenses from the net sales. It’s a very important ratio because it evaluates both the efficiency and pricing policy of a business. This ratio always hints at important business factor whether the ratio is low or high compared to the past or in comparison with the industry.
How to calculate Gross Profit Ratio
The formula is as follows:
|Gross Profit||Net Sales + Closing Stock – Opening Stock – Cost of Goods Sold|
|Gross Profit Margin / Ratios||=||————||=||——————————————————————|
|Net Sales||Sales – Sales Return|
The calculation of the margin is very simple but some components are derived as a result of the management’s discretion particularly the opening stock and the closing stock. The base of the valuation of the stock is decided by the management only. Here is a chance of manipulation. The management may overvalue the closing stock and undervalue the opening stock to show a higher gross profit margin. This thing needs to be taken care of before calculating the gross margin.
Uses of Gross Profit Margin
The gross profit margin is an important ratio being utilized by most of the stakeholders of a business.
The lenders use it to sense the capability of the business to honor their EMIs on time.
It looks at the gross margin to find out their efficiencies/inefficiencies so that they can improve upon the inefficient areas and capitalize on the efficient ones.
The owners look for it to have an idea about the returns, they are going to receive on their capital.
Interpretation of Gross Profit Ratios
The gross profit margin, say 30%, states that 30% of net sales are available to pay off all the operating expenses including selling and distribution, administration, financing, and taxes. The gross profit should be at least equal to all the operating expenses for a business to continue. Otherwise, there would be a net loss and a loss-making business model cannot survive long in the market.
The aim of management is to achieve gross profit margin as high as possible. If the margin is high, the management is considered to be good and effective. Research and analysis of the ratio are required in both the situation whether it is high or low. Finding the reasons behind the nature of the ratio is very important to know if the management is actually efficient or there is some other reason.
Higher Gross Profit Margin
The higher gross profit margin may be a reason for efficient management, low cost of production, an increase in the sales price, or over or undervaluation of stock. All other reasons are valid except the valuation of stock as that does not show efficiency in running the business.
Lower Gross Profit Margin
Lower gross profit margin is a bad sign for any business and it calls for a very extensive and careful analysis. The reason for a lower gross margin may be a higher cost of production, the decline is sales price, or if there is a change in the sales mix. All these factors need in-depth analysis and watch throughout the year to avoid a situation of lower gross margins.