Income statements show gross profits at the very top of the page. That’s why you often hear gross earnings referred to as “top-line earnings”. The figure shows how much a business earns after deducting production expenses. Use this equation to determine gross profits/earnings:
Gross Profit = Revenue – Cost of Goods Sold (COGS)
Additionally, analysts value this measure because other expenses typically stay stable over time. For example, a company takes large one-time loss or gains throughout time. They equal out and negate each other. However, if a company starts producing at a lower cost, they realize more profit. Conversely, if companies start producing at a higher cost, their future growth looks questionable.
Importance Of Gross Profit
Gross profit shows how efficiently a company operates. In fact, some prefer the ratio of Gross Profit/Sales, which is gross margin. Analysts compare gross margin over time, typically quarter-over-quarter (QOQ). Increasing gross margins indicate a company has brighter potential for future investment, which leads to growth. Stock prices typically appreciate on this news. However, the opposite is also true.
Additionally, consider that this measure does not include fixed costs such as rent or advertising. Theses are examples of controllable costs, and successful businesses keep these costs stable over time, making them predictable.
Gross Profit Across Industry
As with many other financial ratios, gross profit varies across industry. This simply means that one should not compare the measure of a food company against that of a hospital. Analysts become familiar with the industry standard and recognize when a business is leading or lagging the average.
How Can You Use Gross Profit?
In conclusion, remember that gross profit is a simple, yet powerful measure of a company’s efficiency. If a company suddenly produces at a lower cost than expected, future expectations for growth increase immediately, along with valuation of the company.