Gross Margin Ratio
Gross margin measures the margin remaining after meeting all the manufacturing expenses including labour, material and other manufacturing costs i.e. the costs which are directly related to the business. It also indicates the efficiency of production and pricing strategies of a company. The range of gross margin varies across industries. The service industry will have a higher gross margin ratio compared to the manufacturing industry as they have lower raw material and manufacturing costs. The ratio is calculated as follows:
Gross Margin Ratio = (Net Sales – Cost of Goods Sold) / Net Sales
Gross margin also indicates the amount of cash available to pay the company’s overhead expenses. A company with a higher gross margin can maintain a descent level of profit as long as the overhead costs like rent, utilities, etc. are controlled.
Trends of the gross margins over a period of time provide a more meaningful insight into the company's strengths rather than a single years gross margin figure. A company earning a consistently high gross margin over couple of years is in a better position to face a downturn in business. However, a company earning a decent but consistent gross margin is considered to be more stable compared to a company boasting a high but a volatile gross margin. Significant fluctuations in a company's gross margin can be a potential sign of fraud or accounting irregularities.