More of this Feature • Introduction • Income Statement • Revenue / sales • Cost of Goods Sold • Gross profit • Gross margin • The first three lines • Operating Expenses • R&D Expense • SG&A Expense • Goodwill Charges • Extraordinary Events • Accounting for extraordinary events • Oper. income/margin • Interest income and expense • Interest coverage ratio • Depreciation expense • Accum. Depreciation • Straight-line Method • Accelerated and Sum of the Years' Digits Method • Dbl Declining Balance • Comparing Depr. Mths • EBITDA • Income taxes • Minority Interests - cost, equity, and consolidated methods • Unreported earnings • Continuing operations • Accounting changes • Preferred dividends • Net income applicable to common shares • Net profit margin • Basic vs. Diluted EPS • Hiding share dilution • Share repurchases • Return on Equity- ROE • Asset turnover • Return on Assets- ROA • Projecting earnings • Formulas & Calculations • Putting it together • Segment 2

Related Resources • Investing Lesson 1 • Investing Lesson 2 • Investing Lesson 3 • More Lessons

From Other Guides • Calculating Gross Profit and Gross Profit Margin • Extraordinary Items on the Income Statement

Elsewhere on the Web • Gross Profit Margin Calculator • Gross Profit and Gross Profit Margin Calculator • Gross Profit Margin Ratio - Calculation and Explanation

Gross Profit Margin
Although we are only a few lines into the income statement, we can already calculate our first ratio. The gross profit margin is a measurement of a company's manufacturing and distribution efficiency during the production process. The gross profit tells an investor the percentage of revenue / sales left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than its competitors and industry is more efficient. Investors tend to pay more for businesses that have higher efficiency ratings than their competitors, as these businesses should be able to make a decent profit as long as overhead costs are controlled [overhead refers to rent, utilities, etc.]

To calculate gross profit margin, use this formula:

Gross Profit
----------(divided by)----------
Total Revenue

For illustration purposes, let's calculate the gross profit margin of Greenwich Golf Supply (a fictional company) using its income statement.

Assume the average golf supply company has a gross margin of 30%. [You can find this sort of industry-wide information in various financial publications, online finance sites such as moneycentral.com, or rating agencies such as Standard and Poors].

We can take the numbers from Greenwich Golf Supply's income statement and plug them into our formula:

$162,084 gross profit
----------(divided by)----------
$405,209 total revenue

The answer, .40 [or 40%], tells us that Greenwich is much more efficient in the production and distribution of its product than most of its competitors.

The gross margin tends to remain stable over time. Significant fluctuations can be a potential sign of fraud or accounting irregularities. If you are analyzing the income statement of a business and gross margin has historically averaged around 3-4%, and suddenly it shoots upwards of 25%, you should be seriously concerned. For more information on warning signs of accounting fraud, I recommend Howard Schilit's Financial Shenanigans: 2nd edition: How to Detect Accounting Gimmicks and Fraud in Financial Reports .

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