What is Gross Margin?
The gross margin is a profitability ratio that shows how much of a company’s revenues are left over after subtracting how much it cost the company to produce its products or services.
How to Calculate Gross Margin
The gross margin is calculated by subtracting cost of goods sold (COGS) from net sales, and dividing the result by net sales. All numbers are found on a company’s income statement.
How to Interpret Gross Margin
The gross profit margin gives an idea about how expensive it is for a company to produce its products and services. Therefore, it is a gauge of management’s efficiency to control the direct costs of revenue while maintaining or increasing revenues.
While the gross profit itself doesn’t tell us much, the gross profit margin is very indicative of the company’s economics.
A company that achieves high gross profit margins (>40%) consistently over 5 to 10 years, and higher than competitors in the same industry or with a similar capital structure is likely to have a durable competitive advantage, or wide economic moat.
In contrast, a continuous downward trend in gross profit margin over several years is a red flag.