Owning a small business isn’t easy; it can take a while before it actually starts becoming profitable. There should be an easy way to determine whether you’re actually making money or not.
Luckily, there is! It’s called the gross profit ratio, and keeps you informed as to how well your business is operating. But what exactly is it and how does it work?
What Is the Gross Profit Ratio?
Also called the GP ration, it demonstrates the relationship between your gross profit and your total net sales revenue. The ratio is calculated by dividing your gross profit figures by your net sales. When the ratio is presented in a percentage form, it is called a gross profit margin or gross profit percentage.
How are Gross Profit and Net Sales Calculated?
Before you can get the GP ration, you have to be able to calculate your gross profit and net sales first. Your gross profit is your net sales minus the cost of goods sold. Your net sales are your total gross sales minus your returns inwards and discount allowed.
For example, your gross sales are $1,000,000, your sales returns are $90,000, and your cost of goods sold is $675,000. Your net sales would be your gross sales minus your salest return: $1,000,000 – $90,000 = $910,000. Your gross profit would then be your net sales minus your cost of goods sold: $910,000 – $675,000 = $235,000.
Why is the Gross Profit Ratio Important?
Although there is no standard for what your GP ratio should be, it’s best to have as high of a ratio as possible. It provides you with a number you can use to price out your products so that they’re both affordable for customers but still provides you with enough profit to cover your expenses and still have money left over.
Also, the ratio can be compared to previous years of performance to see whether the business is actually improving.
What are the Limitations of the Gross Profit Ratio?
The GP ratio isn’t the only means by which a business’ success should be measured. The ratio doesn’t take into account any expenses that have been incurred that are usually charged to the Profit and Loss Account.
The ratio is also only a passive indicator of how well the business is doing. It is possible to have a high ratio, but after all other expenses are taken into account, the gross profits are actually less than calculated. Many businesses consider the Net Profit Ratio to be more accurate, since all other expenses are taken into account in its calculation.
A gross profit ration is only a measure demonstrating the relationship between gross profit and net sales. The calculation is quite popular and is used by almost every single company out there, but it is not a complete measure for judging the overall performance of a business.