Gross margin: Is this an indicator of a company’s financial health?

# Gross margin: Is this an indicator of a company’s financial health?

Updated: 02 Aug 2022, 07:54 AM IST
TL;DR.
The higher the gross margin, the more money is available to a firm to meet other obligations, such taxes, loan interest, and other expenditures, as well as to make a profit. Let us understand it in detail.

We explain here how can gross margin act as an indicator of a company's financial health.

Gross margin, also known as gross profit margin or gross margin ratio, is the difference between a company's sales and its cost of goods sold (COGS), represented as a percentage of sales. It is the portion of a company's revenue that exists after direct costs like labor and materials have been deducted. The greater the gross margin, the more money is available to a business to pay for other commitments, such as taxes, loan interest, and other expenditures, as well as to turn a profit.

Knowing how much money you're generating from whatever you're selling is important and gross margin can be useful for that. It calculates how much money a corporation gets from selling things after deducting direct expenses such as labor costs. Gross margin may be used by businesses to determine the value of a product and how much money should be allocated to its production.

It can be calculated using the given formula-

Gross Margin = (Total revenue- cost of goods sold)/Total Revenue

## How is it different from gross profit?

Although the phrases gross margin and gross profit are distinct, they are sometimes used interchangeably. Both relate to the same concept, i.e. how much of a company's income is left over after producing its goods—but gross margin is a ratio, gross profit is a measure of absolute value. Gross margin, which accounts for relative production efficiency regardless of a company's overall profit level, is a more helpful metric for comparing enterprises to one another.

## Why is gross margin important?

Gross margin serves as a sign of a company's financial stability to shareholders and investors. It gives information on how well a business manages the costs associated with producing items or performing services and how successfully it can sell those same things.

When evaluating a firm for investment objectives, these conclusions are critical to investors. A corporation may invest more in its own growth by keeping a larger portion of its revenue. Such favorable prospects frequently boost investor confidence, which elevates share prices.

While comparing firms in the same industry or with similar companies might be useful, comparing businesses from different industries based on their gross margin has less relevance. Manufacturing and mining are two capital-intensive sectors that frequently have high costs of products sold, translating to relatively low gross margins. Others, like the technology sector, with low product costs generally have significant profit margins

These are the types of ratios used to analyse a company's performance.
First Published: 02 Aug 2022, 07:54 AM IST