Gross Profit Ratio vs Net Profit Ratio - how to read them

Gross Profit and Net Profit are two important components of the Profit & Loss (P&L) Account. It is important that we understand correctly what these terms stand for to be able to arrive at many financial decisions.  

What is Gross Profit Ratio?

Before understanding Gross Profit Ratio, one must know the meaning of Profit Margin. Profit margin is the profitability ratio that shows how money is made in the business. Out of several types of profit margins, the gross profit ratio is the most common type.  

The gross profit ratio is calculated by subtracting the cost of goods (COGS) from the company’s net sales. COGS includes the direct costs incurred by a company on producing its goods, such as raw materials or labour. In simple words, gross profit is the measure of profit a company makes after deducting the costs associated with making and selling its products or providing its services. It is expressed as a percentage of sales.

The Gross profit ratio includes only variable costs and does not account for fixed costs. In addition to this, it only reflects the cost of goods sold. It indicates the percentage of revenue a company earns to apply towards its operating costs. The gross profit ratio is independent. It is calculated in the first stage of the finalisation of accounts. 

What is Gross Profit Margin  

Gross profit margin is the percentage of revenue that exceeds the company’s cost of goods sold. It is one of the many profitability ratios and is used for financial analysis. Gross profit margin measures the initial sales margin before deducting operating expenses such as selling, distributing, administrative, finance, taxes, etc. It is used to determine the prices of goods and services. Thus, the gross profit margin is the difference between revenue and cost of goods sold divided by revenue. 

How to Calculate Gross Profit 

The calculation of Gross Profit varies across different sectors and products. It is used to measure the profitability of a single product. Gross profit calculation can be done by using the formula given below, 

Gross Profit = {(Revenue - COGS) /Revenue}*100. 

In the formula above, you will find the percentage retention rate after all costs have been deducted for each scale. The profit margin percentage is shown as a percentage of the company's profits. 

What does Gross Profit Margin tell you? 

Gross Profit Margin is a good metric for measuring the effectiveness of the company in converting its goods and services into profit. If a company’s Gross Profit Margin changes hastily, this indicates the inadequate management practices of the company. Product pricing adjustments may also influence the Gross Profit Margin. It also indicates the efficiency of the company’s products and sales. The Gross Profit Margin helps the company compare its performance with its peers, providing it a handle to make course corrections to boost its own performance. Moreover, Gross Profit Margin varies from company to company due to the level of competition and industry-specific costs. 

Advantages of Gross Profit Ratio 

As mentioned above, Gross Profit Ratio indicates a company's overall profitability. A healthy gross profit ratio indicates the company's financial well-being and means that the company is running smoothly. The advantages of the gross profit ratio are as follows. 

The gross profit ratio helps compare the business’s net sales to the company’s gross profit. 

It indicates whether the company’s earnings are enough to cover its operating expenses. 

The gross profit ratio helps in comparing the growth of the profit ratio over time to determine the pace of corporate change. 

This ratio is the base for calculating other ratios, including Net Profit and Tax Profit. 

The gross profit ratio acts as a guideline for businesses to change their prices and avail of maximum benefits. 

It is an indicator that helps compare business rivals in the market. 

What is Net Profit 

A company's net Profit is also known as the Net income of the company. It is the indicator of the company's financial standing after all its expenses are paid and provided for from its total revenue. Businessmen, financial analysts, and investors use Net Profit as the bottom line to assess a company's financial health.

Net Profit is calculated by the formula given below: 

Net Profit = Total Revenue - Total Expenses

Net Profit means the total expenses deducted from the total revenue generated. Likewise, the Net Profit margin ratio is calculated by the following formula: 

Net Profit Margin = Net Profit / Sales 

Conclusion

Making profits is the ultimate aim of all companies. Gross Profit and Net Profit are two major metrics used to measure the workings of the company and ascertain whether it is moving on the right track to making profits and growing.