Gross Profit MarginAlthough we are only a few lines into the income statement, we can already calculate our first financial 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.)
Calculating Sample Gross Profit MarginFor illustration purposes, let's calculate the gross profit margin of Greenwich Golf Supply (a fictional company) using its income statement. You will find the statement at the bottom of this page in Table GGS-1.
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 ÷ $405,209 total revenue = 0.40
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.
Gross Profit Margin Over TimeThe 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.
For more advanced readers who own a business or want to understand how to analyze gross profit margins for companies in which they wish to buy stock, I wrote an essay called A Deeper Look at Gross Profit and Gross Profit Margins explaining how it is possible for a company with low gross profit margins to make more money than a company with high gross profit margins. It is definitely worth reading.
This page is part of Investing Lesson 4 - How to Read an Income Statement. To go back to the beginning, see the Table of Contents.
|Greenwich Golf Supply
Consolidated Statement of Earnings - Excerpt
In thousands except earnings per share
|Fiscal year ended||Sept 30, 2007||Oct 1, 2008|
|Cost of Sales||$243,125||$189,000|