What is Gross Profit? Why is it Important?

Gross profit is one of the commonly used items for investors to evaluate a company’s profitability. It is the profit a company makes after subtracting the direct costs(COGS) from total revenue. The calculation is the following formula:

Gross Profit = Revenue - COGS

Revenue, sometimes also refers to as "sales", is the total money made from a company's core business. Direct costs, also known as the cost of goods sold, are expenses required in operation that are directly related to revenue.

Gross profit is important because it measures the business’s ability to generate enough revenue to cover its direct costs.

When taking a deeper look at the gross profit, investors usually use the valuation metric gross margin. Gross margin measures how well the revenue can cover the direct costs. The formula is as follows:

What is worth noticing is that the gross margin for a company alone does not mean that much, because this metric is highly relative. This means that we need to compare the calculated result with similar companies’ results to understand whether the company has a good, average, or bad profitability (according to the gross margin).