In this series of articles, I will explore various financial ratios and metrics used for the analysis of financial statements. These ratios can be used for comparison amongst companies within the same sector to see which company is doing well or poorly. The ratios can also be compared across time to check whether a company is seeing an improvement or a decline in its fortunes.
Let us look at the gross profit margin in this article, which is the first in the series. The gross profit margin is defined as such by Investopedia:
Gross margin is a company’s total sales revenue minus its cost of goods sold (COGS) divided by total sales revenue, expressed as a percentage.
The formula would be written as such:
Revenue – COGS = Gross Profit
Gross Profit Margin = Gross Profit / Revenue
Revenue is the amount of sales a company generates through selling its products or services, while COGS represents the direct costs associated with bringing the product to market or for providing the service to the customer. What the Gross Profit Margin measures is how much profit there is left over for the business after deducting all the associated costs related to selling its products and services, and is an important measure of how well companies can price their products. Pricing power, in turn, determines the strength of a company’s competitive advantage.
Let us look at an example. Suppose Company A and Company B are both in the food and beverage industry and have a chain of cafes and quick-service restaurants. Company A had a gross profit margin of 65% in 2017 while Company B’s was 50%. If we assume that both companies use similar ingredients for their food products, we can conclude from the gross profit margin that Company A is able to charge more for its food and/or is able to source for ingredients at a lower cost than Company B. Looking at the gross profit margin alone would therefore provide useful information on each company, and we may also wish to use the ratio to compare across a whole range of companies within the same industry to determine which has the best gross profit margin.
The gross profit margin can also be used as a comparison across time, as mentioned earlier. In the case of Company A, let’s suppose its gross profit margin was 60% in 2016, and then 65% in 2017. From these numbers, we can conclude that the company was doing something in the right direction – either by increasing its selling prices and/or volumes while keeping its overall costs constant, or reducing its COGS while keeping selling prices steady. Note that we have to delve deeper into the Management Discussion and Analysis Section of a company’s annual report to determine the reasons for the improvement.
In the next article, I shall cover the Operating Margin and show why this ratio is important in determining a company’s expense-control policy. [Editor’s note: The second article in the series discussing the Operating Margin has been published. It can be found here.]
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