Gross Profit Margin: Explained
Like many other financial ratios, gross profit margin helps determine the underlying health of a company. However, this metric has immediate implications for the stock price.
What Is Gross Profit Margin?
Gross Profit analyzes how efficiently a company produces the goods or services it sells. Furthermore, gross profit margin converts this measure to a ratio. Analysts then use this ratio when evaluating a company over time, usually quarters or years. Also, the ratio is Gross Profit Margin = (Revenue – Cost of Goods Sold (COGS)/Revenue.
More simply, it is gross profit/ revenue. It reveals what portion of sales paid for the production costs. Analysts find these data in the income statement. Most noteworthy, the information is among the top line items.
Implications Of Gross Profit Margin
Analysts keep such a close eye on this measure because without adequate margins, businesses cannot pay for operating expenses. Expenses such as salaries, rent, and insurance remain somewhat constant. Margins are ever-changing, based on the cost of production.
Also, if a company sees expanding margins, or starts operating more efficiently, stock prices appreciate on the basis of better future growth. Conversely, the opposite is true.
Elements Of Gross Profit Margin
How does this measure change during a time period? Streamlining or automating supply chain functions are expensive at first, but ultimately lower future margins. This is a sustainable business practice that firms invested in recently. Conversely, new regulation or lower market prices lower gross margins and leave companies cash strapped.
Furthermore, this metric is not uniform across industries. This means that a retailer shows much different gross profit margins than a bank, but the theory remains the same.
Finally, gross profit margin provides value to a myriad of parties from investors to suppliers to producers. Any wrinkle in the number sends a shock to all valuation models, billing cycles, and investment schedules. It is the foremost efficiency indicator of a company.