Gross profit is the amount of money made by a company after subtracting the cost it takes to produce the goods that it sells. This financial metric is determined by taking the cost of goods sold by a company and subtracting that number from the revenue earned by the same company. From this amount, the gross profit margin, which represents the profit as a percentage of revenue, can also be calculated. These two calculations are excellent measurements of both a company's earnings power and its overall efficiency.
There are many different financial metrics used by investors who are trying to gauge the financial strength of a specific company. Perhaps the most basic measurement of strength is the amount of profit that a company earns in a specific amount of time. A company with excellent profits can use them to further strengthen the business, begin new business initiatives, or reward loyal investors with dividend payments. For this reason, gross profit is one of the benchmark measurements used to determine the financial potential of a company.
To determine the gross profit of a company, the financial statements of that company must be studied to gather the necessary information. The necessary components of the equation are the revenue and cost of goods sold. Imagine a company has revenue of $10,000 US Dollars (USD), while their cost of goods sold for the same period is $8,000 USD. Subtracting $8,000 USD from $10,000 USD leaves a total of $2,000 USD in profit.
The company's gross profit margin can now also be calculated by dividing the profit by the revenue. Using the example above, the $2,000 USD profit would be divided by the revenue of $10,000 USD, yielding a margin of .20, or 20 percent. This means that the company in question actually amasses 20 cents in profits for every dollar of revenue that it earns.
These two calculations can be used hand in hand to measure both the company's profit-earning ability and its efficiency in turning revenues into actual profits. For example, a particularly large company might have consistently large gross profits, but a low gross profit margin might be a sign that it is inefficient with its revenue. Both of these metrics are best used when comparing similar companies to each other. Different industries have different benchmarks for how much profit should be earned and how efficiently revenue should be turned into profits, and these benchmarks should be used as the starting point for any useful comparisons.