There are many profitability ratios that could be used as a measure to check the profits generated by the company. These are important to calculate not only to find the profit earned by the company but are also useful to determine the other elements related to profit e.g. amount of tax etc. These profitability ratios are divided into different types and Gross Profit Margin is one such profitability ratio.
Gross Profit Margin:
One of the means to assess the financial condition of the firm is by calculating its Gross Profit Margin. It is calculated to see the number of revenues left after the utilizing of money for Cost of Goods Sold.
It can serve as a mean to predict the extra expenses that could be involved in the business as well as the savings that could be generated for the future. It is also called as gross margin.
Calculating the Gross Profit Margin:
The financial specialists have devised a simple formula with the help of which it is easy to calculate the Gross Profit Margin of the company. All you need is the information from the financial statements of the company.
The formula that could be applied to calculate the GPM is
Gross Profit Margin =(Revenues - costof goods sold ) / Revenues
The information regar(ding the cost of goods sold usually comes from the income statement of the company.
The phenomenon of calculating the Gross Profit Margin of the company can be easily understood with the help of a simple example. Lets us suppose that a random company says ABC deals in producing widgets and earned revenue of about $ 20 million. It incurred about $ 10 million in COGS and other related expenses. So, the ABC Gross Profit would be calculated by following method:
Gross Profit Margin = (20 million - 10 million)/20 million = $ 0.50 or 50%.
This amount of $ 0.50 is an indication that at the end of the day each dollar earned by ABC would generate a profit of about $ 0.50 for it. The higher the GPM of a company the better it is. You can compare this figure of your company with that of yours competitors. While interpreting the Gross Profit Margin, it is important to known the type of industry in which the company is operating as it can greatly influence the analysis and interpretation.
Importance of Calculating Gross Profit Margin:
· As mentioned earlier, Gross Profit Margin is a key factor to analyze when analyzing the profitability and profit-generating abilities of the company. By carefully taking this measure into consideration, it becomes easier for the investors and by the analysts to decide the best and to compare all the companies in the whole industry. This is also a factor to show that whether the product or service of the company is capable of generating profit or not. So, higher the percentage of GPM, better the chances for the company to generate profits after covering its costs.
· It can also be used as a base to determine the pricing, cost structure and production efficiency of the company.
· It also serves as a measure to know how much a company could spend for its operating costs so that after covering these costs it could also generate profit as well. So, it means that if the GPM of the company is higher it is a clear indication that the company can generate a high level of profits even after paying all its operating costs.
· The high Gross Profit Margin of a company also attracts greater number of investors who would willingly invest their money in your company as it could act as a guarantee that they will earn a return on their investment.
Hence the company with high Gross Profit Margins is considered to be the good profit generating companies operating in any industry and hence, could be categorized as the competition winning company.