The gross profit margin, as explained in Axel Tracy’s 2012 book, “Ratio Analysis Fundamentals: How 17 Financial Ratios Can Allow You to Analyse Any Business on the Planet,” measures “what percentage of each dollar of sales revenue remains after the cost of purchasing or manufacturing the inventory.”
Tracy does not distinguish between profit margin and gross profit margin, but it may help to know that "profit margin" is also known as "net profit margin," thus we have a difference between "gross" and "net." Profit margin is a net figure because it deducts all costs, while gross profit margin is "gross" because it accounts only for cost of goods sold. More specifically, gross profit margin does not include such items as sales and administrative costs.
As the information above indicates, gross profit margin is especially relevant in the retail and manufacturing industries. When used in the service sector, costs of goods sold likely refers to staff costs rather than inventory. Note, too, that cost of goods might also be known as cost of sales or cost of revenue.
According to the author, the gross profit margin matters:
“It is an important indicator for both investors and business managers because it tells us how much funds are left from sales revenue to pay all our remaining expenses while also having net profit left over. If a business cannot generate a large enough gross profit from its sales, then there is pressure on the bottom line when financial reports are generated, and ultimately the viability of the business.”
Here is the formula for calculating it: Gross Profit Margin = (Sales Revenue – Cost of Sales) / Sales Revenue.
For example, sales revenue ($3 million) – cost of sales ($2 million) / sales revenue ($3 million) = gross product margin (33.3%). That 33.3%, or $1 million, is available to the company to pay for all remaining costs and capital expenditures. If those costs are less than $1 million, the company will show a profit.
The sales revenue and cost of goods sold information comes from the income statement (also known as the profit and loss statement).
The gross profit margin can, and often does, change over time, and, of course, all companies want to grow it (although they’re not always able to do so). From an investor’s perspective, a rising gross profit margin could mean that final selling prices are going up faster than the cost of inventory.
This can happen because the company has been able to increase its prices without losing customers. It’s not covered in this book, but that failed to happen when Netflix NFLX increased its prices earlier this year. The Financial Post reported on July 17 that:
“The world’s largest paid online TV network said Wednesday it lost 130,000 customers in the U.S., the result of higher prices and a weak slate. It signed up 2.7 million subscribers globally in the period, also missing projections. The company forecasts seven million new signups this quarter, as several top shows, such as Stranger Things and Orange Is the New Black, return to the service.”
In other words, Netflix believed it could increase prices without losing subscribers, but by the end of the second quarter, it had been wrong, at least in the short term. More customers dropped off than expected, and fewer signed up than expected. The company thinks it can turn that around in upcoming quarters, though it now faces more competition from heavyweights like Disney DIS and Apple AAPL.
Tracy pointed out that companies can increase their prices while keeping their customers if they have pricing power. Pricing power comes from a moat or an economic moat. It means a company has products customers can’t find elsewhere or because its products are far superior to those of competitors.
In addition, he noted that sometimes companies gain pricing power because of increased demand, writing, “This situation is normally the result of external factors and management’s ability to capitalize on them. There could be, for examples, production difficulties within a large competitor and a sharp manager could meet their unmet demand quickly without input costs increases flowing through the supply chain.”
There is also an arithmetic reason for improvement in the gross profit margin: The cost of sales has gone down in relation to sales revenue. Tracy wrote that this can happen because of increased market power, citing the case of Walmart WMT. As it came to dominate more and more of the retail sector and bought increasingly larger volumes, it could push its suppliers into lowering their prices (which were Walmart’s cost of inventory or cost of goods sold).
Other companies may accomplish this by switching to a lower-cost supplier or manufacturer. And, there are economy-wide reasons why a company’s gross profit margin may increase, such as a change in commodity prices. The author used the example of Starbucks SBUX. He wrote, “They may do absolutely nothing at all different from the previous period but if coffee growing regions have a boom season and there is a glut of Arabica beans on the market then their cost of sales will fall as the price of coffee beans has fallen.”
If the gross profit margin is falling, there may be internal or external reasons. Externally, this can happen when one company in an industry discounts its prices in a bid to gain market share, despite paying the same, full price to suppliers. This can affect all players in an industry.
The margin can also fall because suppliers increase their prices, but final sellers cannot. This has happened when there is inflation in the supply chain, but the final sellers are in highly competitive markets.
While the gross profit margin is important for investors and managers, it does have drawbacks. Like the net profit margin, the gross margin is usually not applicable across industries. Tracy used the example of software companies with high margins and food retailers with low gross product margins.
The section on gross profit margins ended with these words of caution and advice from the author:
“Finally, the formula to this ratio simply takes two inputs and ignores a significant amount of other financial information important to a business. A great Gross Profit Margin may be useless if management is inefficient in other areas and has severely bloated expenses elsewhere. In other words, the ratio is no indicator of the final, bottom line net profit, or funds available for dividends or retained earnings.”
Conclusion
Gross profit margins tell investors and managers how much cash is left for other expenses, after the cost of producing the goods for sale.
More broadly, this ratio helps investors understand the revenue and cost dynamics within the financial statements. Margins may go up or down, as explained above, and if they do, it should signal to investors that they need to investigate why the change is happening. Is the company responding to external conditions, or is there something going on internally that reflects badly or well on management?
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
- Ratio Analysis: The Profit Margin
- Beating the Street: 25 Golden Rules
- Beating the Street: Peter Lynch on Cyclical Stocks
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