In the course of its activity, every business owner has to calculate different financial indicators to know where to guide its small business. They are needed to assess the results of its work and identify the level of profitability. One of the main indicators of the company’s work is gross profit.
This is the total revenue generated during the reporting period or the difference between the revenue and the cost of the product or service sold. This concept combines the profit from all areas of operation, except for production costs. The value of the indicator should be displayed in the Balance sheet.
What is a good gross profit margin? Gross margin is a measure of the financial success of a particular product or service. The higher the profit margin, the more efficient a company is and the less the company deducts from each dollar in sales to cover its other costs and obligations.
This indicator depends entirely on the business in which the company operates. Investors and analysts compare one company with similar companies in the same industry in order to understand who has a higher gross margin, which is one of the key parameters for investment.
Gross margin ratio
The gross margin ratio deserves increased attention as well. This is its ratio to the amount of revenue, which is presented as a percentage. This value is a profitability ratio that calculates how each sales dollar contributes to the gross margin. A high ratio indicates a large profit, plus there is complete control over all the costs. If it turns out to be in the low percentage range, then this indicates a lack of proper control over the cost of goods and services.
The ratio is often used in the process of general monitoring of the state of the business, comparing past segments of activity, and forecasting future work. In addition, with its help, you can get detailed information about the effectiveness of the company in comparison with competitors. It is a multifunctional indicator that is used in many areas of business activity. You can see the formula for determining the value of the gross margin ratio below.
Pros and cons of gross margin ratio
The problem with the gross margin is that you cannot really compare two companies because it gives you dollar amounts, similar to the net income. For example, your small business makes only $150,000 in sales and you want to compare it to a company with $3 million in sales.
For example, your business has $89,000 for the COGS, so your gross margin is $61,000. The large enterprise has $2.7 million in cost of goods sold and what is left over is $300,000. It might seem that the larger business is much better off than your small company just based on the gross margin. This is where the gross margin ratio comes in. If we calculate this indicator for both companies, we get 40.67% for your small company and 10% for the big company. This means that you get to keep roughly 40 cents worth of profit from every dollar you invest, while the large company only gets to keep 10 cents on every dollar.
We can summarize everything as follows:
- Helps to identify significant changes in the company’s profitability in the early stages
- When compared with companies in the industry, helps to determine the competitiveness and efficiency of the company
- Easy to calculate and understand.
- This figure does not include other expense items.
As you can see, this financial ratio allows one to look at the company and its profits from a different point of view and plays an important role when comparing different businesses.