Gross Profit x 100%  Year 1  Year 2
 Sales                              35%  50%

Which of the following would describe these results:

 A) On the face of it year 2 appears to be doing better than year 1.
 B) On the face of it year 1 appears to be doing better than year 2.
 C) Year 1 profitability is better than year 2.
 D) Year 2 profitability is better than year 1.

Note of caution:
Remember Ratio Analysis is all about comparing one set of ratios with another.
This can mean comparing one year with another as in the above exercise, or comparing the performance of one company with another or with its budgets.
To achieve greater confidence in the conclusions you draw, you really need to compare more values than just two. You also need to bear in mind that there is some flexibility in the accounting treatments adopted by accountants when preparing the financial statements and so differences observed in performance might in part be due to differences in the way items have been treated in the accounts rather than differences in performance.

Answers to gross profit questions

A) On the face of it year two appears to be doing better than year one.
     year two has a greater profitability ratio and it might  therefore  be more profitable.
     You would need more information in order to be sure. For instance:

• The results of the last 5 years would indicate whether the 50% was a one-off result and therefore not indicative of a general improvement in profitability.
• Comparisons to world class companies would indicate relative performance. For instance if other companies had a GP ratio of 75% the your own ratio of 50% seems not so good.
• Comparisons to budgets would indicate whether performance was better or worse than expected.
• Information about the method used to value closing stock is necessary in order to determine if the differences are not due to performance improvements but due to differences in accounting treatments adopted. For instance if in the first year a method is used which values stock on the low side and then in the subsequent year one is used which values stock at much higher prices then you would expect a higher GP ratio to be reported in year 2.

2 Gross Profit Ratio                  =   Gross Profit  x  100 = %
                                                            Sales

3 Net Profit Ratio                      =   Net Profit      x  100 = %
                                                           Sales

Efficiency Ratios
4 Stock Turnover Ratio            =  Cost of Goods Sold =  No of times
                                                          Average Stock

5 Fixed Assets Turnover Ratio =  Sales                       = No of times
                                                        Fixed Assets at NBV

6 Debtor Collection Period        =  Average debtors     x 365  = No of days
                                                                   Sales             x   52  = No of weeks
                                                                                         x  12   = No of months

7 Suppliers Payment Period       =    Creditors               x 365   = No of days
                                                          Purchases               x  52    = No of weeks
                                                                                          x  12    = No of months

8 Asset Turnover                       =      Sales                      = No of Times
                                                     Capital Employed

Liquidity Ratios
9 Current Ratio                          =   Current Assets        = Expressed as a
                                                       Current Liabilities        Factor

10 Quick or Acid Test               =  Current Assets - Stock [Also expressed as a Factor]
                                                        Current Liabilities

Investment Ratios
11. Gearing                                 =  Preference Shares + Long Term Loans    X  100%
                                                        Shareholders funds + Long Term Loans

A Note of caution:
Ratio Analysis is all about comparing one set of ratios with another.
This can mean comparing one year with another, or comparing the performance of one company with another or with its budgets.
To achieve greater confidence in the conclusions you draw, you really need to compare more values than just two. You also need to bear in mind that there is some flexibility in the accounting treatments adopted by accountants when preparing the financial statements and so differences observed in performance might in part be due to differences in the way items have been treated in the accounts rather than differences in performance.
Now test your understanding by attempting to calculate  the gross profit ratio  from our own figures.
First you need to know whether to examine  the  trading, profit and loss account or the balance sheet.
If you make a mistake you may return here, for another try, by pressing your internet return button. You must return to this point in any event if you wish to take a peep at the answer
 Trading, profit and loss account          Balance sheet

The answer to the gross profit ratio

Gross profit ratio =     gross profit     =    £1,500      x 100%       =  75%
                                         sales                   2,000
This means that the business makes a gross profit of 75p on every pound of sales it achieves.
Notes.
These figures are found on the profit and loss account.

 Return to learning about gross profit