Financial ratios obtained from the income statement usually express the expense and earning
positions in the income statement as a fraction of total sales in order to turn them into comparable figures. Expressing income statement positions as fractions rather than absolute numbers makes it
easier to compare them to previous years’ figures and allows for the comparison of income statements of
competitors, different industries, businesses in different countries and – to a limited extent – even other
accounting systems.
Gross profit margin
The gross margin is one of the most prominent financial ratios in nearly every analysis. It
expresses the gross profit as a percentage of revenues:
Gross profit margin =Gross profit/Revenues
The gross profit margin (GP margin) is important for two reasons. First, the cost of sales,
which determines the gross profit, is usually the single largest expense position in the income
statement. Second, even the most efficiently run company cannot survive without sufficient
gross profit to pay for the various fixed costs, interest payments and taxes incurred as a result
of running a business.
When compared with other companies, the gross profit margin also indicates the pricing power and input price sensitivity of a company, as can be shown by a simple transformation of this ratio into the related cost of sales margin (CoS ratio):
Cost of sales ratio = Cost of sales/Revenues
The lower the cost of sales for each unit of revenue, the higher the gross profit margin. In essence it can be said that companies with high gross profit margins are less exposed to input price increases and generally possess a strong basis for negotiation with their customers (higher prices), suppliers (lower wholesale prices) and even their employees (lower salaries).
Whereas the gross profit margin demonstrates how much profit remains after paying for the direct costs of the product, the cost of sales ratio simply demonstrates the costs associated with every transaction. Hence this figure can be viewed as the reciprocal of the average mark-up a company can realize. When Company A sells apparel for $10 which it purchased for $8 from the manufacturer, its gross profit margin would amount to 20%, its cost of sales ratio to 80% and the mark-up would therefore be 25% (1/0.8 – 1).
In this sense, both ratios are two faces of the same coin, telling the same story but from different perspectives. It is very important to understand which input prices drive the cost of sales for each company. Steel and aluminium producers, for example, are highly dependent on the exploitation and availability of their respective raw materials as well as energy prices. Besides a static analysis of these ratios, it is therefore usually advantageous to compare the development of the gross profit or cost of sales margins and the price trend of the relevant input materials over the past few years.
For guidance with Interpreting your financial data contact Dawgen Global Financial Consultants at : [email protected]
