What are Gross Profit Ratio and Net Profit Ratio?

A profitability ratio that establishes a relationship between the gross profit of a firm and its total net sales is known as Gross Profit Ratio or GP ratio. This ratio can be quite helpful in the evaluation of the operational performance of the concerned business. The GP ratio is actually the portion of gross profit in the net sales and hence derived by dividing the gross profit by the net sales of the firm/ business.

Formula:

Gross Profit Ratio = Gross Profit/ Net sales

Now, when the gross profit ratio is explained in form of a percentage, the ratio is multiplied by a hundred so as to arrive percentage and it is signified as gross profit percentage or gross profit margin.

Gross Profit Ratio = (Gross Profit/ Net Sales) x 100

The two basic components in the GP ratio are net sales and gross profit, information regarding which is available in the income statements of the firm/ business/ company. Gross profit is arrived upon by subtracting the cost of goods sold (COGS) from net sales, however, net sales are calculated by subtracting return inwards and discount allowed from the gross sales.

i.e. Gross Profit = Net Sales – COGS

And, Net Sales = Gross Sales – Sales Return – Discount Allowed

For example: Given gross sales: Rs 100,000, sales return: Rs 10,000 and cost of goods sold: Rs 60000; calculate GP ratio.

Solution:

Net Sales = Gross Sales – Sales Return = Rs 100,000 – Rs 10,000 = Rs 90,000

Gross Profit = Net Sales – COGS = Rs 90,000 – Rs 60,000 = Rs 30,000

Hence,

Gross Profit Ratio = Rs 30,000/ Rs 90,000 = 1/3 = 0.333

Converting to percentage it comes out to be 33.33%

Significance and Interpretation:

Gross profit is considered very important for any type of business as it is utilized to cover major expenses and carried over into profits. As such, there is no benchmark or standard GP ratio but the higher the GP ratio, the better for the firm.

GP ratio: It is derived every year while analyzing the financial statements of a firm in order to compare it with previous years as well as other competitors in the industry. If there is significant consistent improvement in the GP ratio over a period of time is considered to be an indication of continuous improvement.

While comparing the ratio with other players in the industry, adherence to the same accounting systems and principles is expected from the analysts. Ratios derived by application of different accounting systems and principles cannot be compared or even if compared, it will be useless.

Net Profit Ratio (NP Ratio): It is a commonly used profitability ratio that establishes a relationship between the net profits after tax with net sales. Just like the GP ratio, the NP ratio is also an indicator of the operational soundness of the business.

Net Profit Ratio = Net Profit after Tax/ Net Sales

Here, Net profit after tax is derived by subtracting operating expenses and income tax from the business’s gross profit. In this regard, all the non-operating revenues and expenses are ignored because the ratio is to be calculated in order to arrive at the operational soundness and profitability of the firm which is from its primary operations only.

The non-operating revenues include interest/ return on investments and income from the sale of its fixed assets; however non-operating expenses include interest on loans and loss on sale of fixed assets. Now, when this ratio is expressed in form of a percentage, it needs to be multiplied by a hundred and is termed as net profit margin. It is actually the relationship between net profit after taxes and net sales in percentage.

Net Profit Ratio = (Net Profit after Tax/ Net Sales) x 100

For example: Given gross sales: Rs 100,000, sales return: Rs 10,000, net profit before tax = Rs 20,000 and Income tax = 10%; calculate net profit ratio.

Solution:

Net profit after tax = Rs 20,000 – 10% of Rs 20,000 = Rs 18, 000

Net sales = Rs 100,000 – Rs 10,000 = Rs 90,000

Hence,

Net profit ratio = Rs 18,000/ Rs 90,000 = 1/5 = 0.20

Alternatively, the ratio can be expressed in percentage by multiplying it with 100

Net profit ratio = 0.20 x 100 = 20%

Significance and Interpretation:

NP ratio is an important tool that measures the business’s overall profitability and tells the position of operational and managerial efficiency of the business. The higher the NP ratio, the more efficient the firm is operational. There is no such standard or benchmark in the NP ratio however its ratio can be compared with the previous year’s ratio and ratios of competitors in order to reach the relevance of computation of such ratio.

Similarly, the industry’s average and budgeted NP ratio can also be used for comparison purposes. A business can be taken to be getting operationally efficient if its NP ratio is increasing consistently over a period of time.