Gross Profit Margin – 2 of 6 in series on financial ratios

Let’s now look at a second useful profitability ratio (see the previous post also). The Gross Profit Margin is a simple ratio which shows the percentage profit made on sales before deducting business expenses. It is calculated as follows:

Gross Profit  x 100

Sales

The Gross Profit Margin will vary by business sector. For example, some businesses/sectors may make quite a large Gross Profit Margin on each, but have lots of overheads to pay e.g. the hospitality sector, like pubs and clubs. Other sectors may have a much lower figure. The Gross Profit Margin is usually closely watched by business owners in particular.  If you remember that Gross Profit is Sales less Cost of Sales, and Cost of Sales in turn includes opening/closing inventories and purchases. With any abnormal changes in these figures the Gross Profit Margin will change.It might be something simple like an increased purchase price which has not yet been passed on to customers through a price increase, or it could be something more sinister like theft or stock or unrecorded sales.

As in the last post, let’s use the accounts of Diageo plc as an example. Based on their 2010 Income Statement (p.106 of the annual report), the Gross Profit Margin is;

5681 x 100    = 57.5%

9870

If you do the same figure for 2009 it’s 58.1%, which is in a similar range. Most business managers will know what their average Gross Profit Margin is. Although the Diageo figure seems high, there are lost of expenses to be paid out of the Gross Profit. You can also calculate a Net Profit Margin, which use the Net Profit before tax instead of Gross Profit in the above formula. This is not as useful as the business expenses tend to be more variable from year to year, although it is still widely used.