Gross MarginAnalyzing Firms
Gross Profit is the easiest profit to locate on the income statement. You find this value by subtracting Cost of Goods or Services Sold from Sales Revenue and dividing the result by Sales Revenue. You can multiply this number by 100 to express the Ratio as a percentage.
The Gross Margin Ratio is useful mainly for comparing firms in the same sector that are competitors with each other. This displays who can complete their products and services for a less expensive cost in percentage terms. However, it is very important to read the Income Statement’s notes to determine the details of what is being qualified as both sales and costs of goods sold. Reading the notes will reveal potential distortions, and allow you to ensure that the Gross Margin Ratios of the companies are actually comparable.
The Gross Margin Ratio offers a reasonable indication of the profitability of the firm or business. They also indicate trends over years. Trends are best viewed in percentages, allowing you to determine if the declines are accelerating or decelerating. If Gross Margin Ratio as a percentage is decreasing over time, it indicates one of two business problems, or potentially both. The first problem is increasing Costs of Goods Sold over time decreasing overall gross profit. This may indicate problems with the supply chain for materials or labor, such as scarcity increasing supply material prices or increased labor wage demands. The second problem is falling revenue due to slowing sales or decreasing prices charged. This indicates customers are avoiding the company or competitors undercutting the firm’s pricing and forcing the firm to drop its pricing to match. You should avoid firms in those situations.
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