Company financials are a valuable resource that most investors don't use to their full potential. When you look closely at how a company is doing financially, you can glean useful information that can help you invest more successfully. Margins are a metric that assess a company's efficiency in converting sales to profits, and different types of margins focus on different parts of the business process. Gross margin gives insight into the ability of the company to deal with production costs in an efficient manner that can produce profits further down the income statement.
What gross margin is
The definition of gross margin is simple. To calculate it, take the company's gross profit and divide it by its total revenue. The resulting percentage is the gross margin.
Of course, that only sheds light on the question if you know what those terms mean. Total revenue is easy to understand, but calculating gross profit requires subtracting out the cost of goods sold. Cost of goods sold is an accounting term that refers to expenses that are directly related to the production of whatever a company sells. Other expenses, such as the costs of distribution, general overhead, and research and development, aren't included in cost of goods sold. Instead, they're considered operating expenses and show up further down in the income statement.
For example, consider a business that makes wool socks by hand. The cost of the wool that goes into the socks and the wages for the workers who turn that wool into wool socks would be costs of goods sold. Subtracting those expenses from the total sales will give you gross profit, and dividing that figure by total sales will give you the gross margin.
Why gross margin is important
Gross margins are useful for comparison purposes, but you have to be careful in doing so. Within a given company, looking at how gross margins change over time gives you a sense of the trend toward greater or less efficiency in production activity. Comparing gross margin figures for multiple companies within the same industry can also be useful in signaling which businesses have the most efficient operations.
Gross margins have more limited value in comparing companies in different industries. Capital-intensive industries will often have very high costs of goods sold, translating to relatively low gross margins that nevertheless still provide a solid profit opportunity. Other industries might have very small costs of goods sold that produce high gross margins, but large operating expenses can eat up most or all of that gross profit and thereby lead to less attractive net income figures.
Gross margins provide an easy but effective way of looking at one element of a company's business operations. They also offer a compelling first step in assessing the entire income statement of a business, which is something that all good investors should look at more closely with the companies whose shares they own.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at email@example.com. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.