If you run a business or you’re considering investing in a particular company, you may be concerned with profitability. A company’s financial health can be measured in different ways, including gross margin and gross profit. While they may sound similar and they can both be reported on income statements, they’re each used differently to gauge a company’s performance. Understanding those differences will make you a better investor. It might also behoove you to consult with a financial advisor as you go about strategizing your investments.
Gross Profit, Definition
To understand gross margin, you first have to understand gross profit. Gross profit means a company’s total sales, minus the cost of generating revenue. A simpler way to define gross profit is as sales less the cost of goods sold. Cost of goods sold, or cost of services provided, includes expenses such as:
- Manufacturing costs
For example, say your company generates $1 million a year in revenue. Your cost of goods sold over that period is $600,000. If you follow the formula mentioned earlier, your gross profit would come out to $400,000.
Gross profit, always expressed as a dollar amount, is a simplified way of looking at profitability. For this reason, it’s sometimes referred to as a top-line earnings measure since you can easily calculate the amount of profit you’re making from the sale of goods. You can find gross profit calculated on financial statements for a business or company, including profit-and-loss statements.
Gross Margin, Definition
Gross margin measures profitability in terms of how a company’s revenue exceeds its cost of goods sold (or is exceeded by its cost of goods sold). The formula for calculating it is gross profit divided by revenues, and it’s expressed as a percentage.
So going back to the previous example, if your company has a $200,000 gross profit and $1 million in revenue, your gross margin would work out to 0.2 or expressed as a percentage, 20%. This margin can be used to measure how well a company generates revenue versus managing costs. Using this example, it means that 80% of its revenue is eaten up by production costs.
The higher the gross margin is, the better, because it means a company has more money to invest in growth, add to liquid cash reserves, pay down debt, hire more people or cover indirect operating expenses. Companies that have a high gross margin are generally considered to be reaping more profits from product sales compared to companies with a lower gross margin.
That’s good news if you run a business because you want to keep cash flowing efficiently so you can scale your company up. As an investor, you may be drawn to companies with a higher gross margin since that could suggest greater earning potential over the long-term.
Gross Margin vs. Gross Profit: Which One Should You Use?
If you’re evaluating a company to invest in, you may wonder which measure is better for considering financial health. In reality, both gross margin and gross profit can be useful for getting an accurate picture of a company’s profitability.
Both calculations are easy to make if you know a company’s revenue and cost of goods sold. You can even go back to previous years to estimate how gross profit and gross margin are trending over time to see how well a company has performed. And companies can use these calculations to pinpoint areas where they may need to reduce expenses or increase production efficiency to become more profitable.
You should keep in mind, however, that neither figure accounts for all of the various costs associated with running a business. For example, gross profit doesn’t factor in taxes, accounting fees or marketing budgets as part of the cost of goods sold. Not having those numbers added in could skew profitability figures.
And these measures also don’t take into account strategic moves companies might make that can affect profitability. Taking on debt, for example, or restructuring pricing can both impact the bottom line, which may not be evident just by looking at gross profit or gross margin.
Something else to consider is that profitability can be affected by industry and there’s no uniform guide for making comparisons across different sectors. For example, you may see wide gaps in gross profit and profit margin between the retail and financial services industries or between manufacturing companies and energy companies.
Other Financial Ratios to Consider
Gross profit and gross margin can tell you two very specific things about a company’s performance. But as an investor, there are other financial calculations and ratios to keep in mind that can help you be better informed when making investment decisions.
Those calculations and ratios include:
These, along with gross margin and gross profit, can give you a truer sense of how a company is performing in terms of the money it’s making and the money it’s spending. The better a company is at managing cash flow and assets and keeping debt levels low, the more that it can strengthen its financial foundation and growth outlook for the long-term. All of these things can be reviewed by reading a company’s annual report, which breaks down its financials for the previous year.
The Bottom Line
When analyzing companies as you decide where to invest your money, it’s important to look under the hood to get a feel for how they are doing. Assessing gross profit and gross margin are two key ways of doing that. Likewise, if you run a business, these two metrics are likely something you’re keeping a close eye on as your operation grows. Knowing the difference between gross profit and gross margin, and why they matter, can help you make more informed decisions about what to do with your money as an investor or as a business owner.
Tips for Investing
- Consider talking to a financial advisor about gross profit and gross margin and how they can affect your portfolio. If you don’t have a financial advisor yet, finding one doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- There are different approaches you can take to review a company’s financial health when determining whether to invest. Fundamental analysis, for example, means looking at a company’s operations. Technical analysis, on the other hand, focuses on how a company reacts to current market trends.
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