Accounting – 6.2 Interpretation of accounting ratios | e-Consult

Gross profit and profit for the year are interconnected, with gross profit being a crucial component in calculating the final profit figure. Gross profit is calculated as Revenue less the Cost of Goods Sold (COGS), which includes the cost of the inventory sold. The valuation of inventory directly impacts gross profit; a higher valuation of inventory (e.g., due to obsolete or slow-moving stock) will likely lead to a lower gross profit. Conversely, a more accurate and up-to-date valuation will provide a more realistic gross profit figure.

The rate of inventory turnover also plays a significant role. A high rate of inventory turnover indicates that goods are being sold quickly, reducing the amount of time inventory sits in storage and potentially reducing storage costs. This can lead to lower COGS and, consequently, higher gross profit. A low rate of turnover suggests slow sales, potentially leading to increased storage costs, obsolescence, and higher COGS, resulting in lower gross profit.

Revenue is the starting point for calculating gross profit. Higher revenue generally leads to higher gross profit, assuming the cost of goods sold remains relatively constant. Expenses (e.g., administrative, selling, and distribution expenses) are deducted from gross profit to arrive at profit for the year. Higher expenses will reduce profit for the year.

The accounting equation (Assets = Liabilities + Equity) is fundamental. Profit for the year directly impacts equity. Profit increases equity, while losses decrease equity. Therefore, changes in gross profit and subsequent expenses flow through to the profit for the year, ultimately affecting the company's equity position. A consistently high gross profit, coupled with controlled expenses, will contribute to a healthy increase in equity.

In summary, the relationship is a chain: Inventory valuation and turnover influence COGS, which directly impacts gross profit. Gross profit is then used to calculate profit for the year after deducting expenses. Profit for the year then directly affects equity. All these elements are interconnected and must be considered holistically.