Gross margin is a financial measurement that reveals how much it costs for companies to manufacture the goods it sells. It is the most bare-bones measurement of a companies performance. However, it is perhaps the most important profitability measure for investors.
Breaking Down Gross Margin
Gross margin (GM) equals a company’s sales revenue minus the cost of goods sold (COGS), then divided by the total sales revenue. This gives investors a universal percentage measure- easily comparably across companies and also over time.
Additionally, the measurement tells analysts the amount of each dollar a company retains after creating the product. Increasing GM comes in two ways. First, reducing COGS through buying supplies cheaper or automating processes. Second, companies increase price or create new demand for new products.
Uses Of Gross Margin
Furthermore, this metric is of extreme interest to investors and analysts. For example, companies who improve gross margins are suddenly more profitable and more attractive. Conversely, falling margins signal sloppy cost management or lack of demand. Slipping margins sometimes causes companies’ stock price to plummet, sometimes for entire quarters.
Also, gross margin is important because it tells interested parties how companies are performing in relation to their core activities. This metric leaves out expenses such as administrative expenses, and focuses on direct materials related to the products. Administrative expenses are more easily controlled than integral costs such as direct materials, thus emphasizing the important of gross margin.
Also, inventory turnover is a noteworthy consideration. For example, high inventory turnover accompanied with low gross margins is similar to low inventory turnover with high gross margin in a numbers sense. However, it signals differences in business practices that professionals are cognizant of.
Gross margin trends are imperative when analyzing a company’s financial health. Often times, they signal changes in future prices of the company’s stock. This is why gross margin draws the attention of traders, analysts, and investors, among others.