Gross Profit Ratio Analysis

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Gross profit is one of several measures of profitability.
Gross profit is one of several measures of profitability. (Image: money ussr’s money image by Pali A from Fotolia.com)

Gross profit is defined as sales minus costs related to those sales. A gross profit ratio is gross profit expressed as a percentage of revenue. Gross profit is one of several measures of profitability. Investors use it to gauge the efficiency of a company and to see how much money is left over to pay for operating expenses.

Calculating

To calculate gross profit, go to any company's income statement. Find the lines marked revenue and cost of goods sold. Subtract cost of goods sold from revenue. The answer is the gross profit of a company. Take the answer, and divide it by revenue to calculate gross profit margin.

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Analysis

Repeat the calculation, this time with a different year or comparable period of the company's results. Doing this will give a picture of a company's health over a period of time. Calculating gross profit for competitors gives a good idea about how a company stacks up against peers.

The Bottom Line

Companies have other expenses aside from the cost of goods sold, so gross profit isn't the ultimate measure of profitability. Additional expenses, such as interest and administrative costs, are also subtracted to give net income, also known as the bottom line.

Use to Investigators

Tax investigators use gross profit margin in a search for illegal operations. In the book Financial Investigations and Forensic Accounting, George Manning writes that higher-than-average gross profits can be an indication that criminals are adding cash to a business to launder the source of illegal funds. Lower-than-average profit margins are an indication that someone in the company is removing cash for the purposes of evading taxes.

Importance

According to VentureLine's dictionary of accounting terms, gross profit measures a company's efficiency. For manufacturers, it's the efficiency of turning raw materials into products. For retailers, it is a measure of markup over wholesale.

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