The Influence of Inventory Changes on Gross Profit

Gross profit equals total revenue minus the cost of goods sold.

A company's inventory levels play an important role in financial ratio analysis. Corporate finance specialists review inventory amounts, cash levels and accounts receivable to gauge a firm's short-term liquidity levels and financial robustness.

Definitions

Gross profit indicates a company's prowess in converting purchased goods into sales in the short term. This financial indicator equals total sales revenue minus the cost of goods sold. Goods sold are raw materials or finished products that a company sells over a period of time. Inventories are short-term assets, or resources, that a firm intends to use in operations within 12 months.

Inventory Changes on Gross Profit

A change in a company's inventory amounts affects corporate gross profit levels. To illustrate, a small manufacturing firm has $1 million worth of goods at the warehouse. The purchasing manager does not place any order during the month. At the end of the month, only $400,000 worth of goods is available at the warehouse. The firm's accountant records $600,000 ($1 million minus $400,000) as the cost of goods sold. If the firm's monthly sales revenue is $2 million, the gross profit for the month amounts to $1.4 million.

Considerations

A company's gross profit affects its gross margin. Gross margin equals gross profit divided by total sales revenue, and measures profitability levels.

References

• Investopedia: Gross Margin
• Investopedia: Fundamental Analysis: Introduction
• Understand Accounting: Inventory and Costs of Goods Sold